Making a new S election after termination
Editor: Linda Markwood, CPA
August 1, 2020
September 2, 2020
Regulations coming on S corporations with accumulated E&P and GILTI
September 1, 2020
Private equity and F reorganizations involving S corporations
August 1, 2020
State and local considerations in using an F reorganization to facilitate an acquisition
S Corporation Income Taxation
Generally, once a corporation has revoked or terminated its S election, the corporation (or a successor corporation) must wait five years before it can reelect S status, unless the IRS consents to waive the five-year period. Technically, the corporation (and any successor corporation) is not eligible to make an S election for any tax year before its fifth tax year that begins after the first tax year for which the termination was effective unless the IRS consents to the election (Sec. 1362(g); see also IRS Letter Rulings 9033041 and 9634021). This five-year rule applies whether the termination was voluntary or involuntary.
Example 1. Calculating the five-year waiting period: XYZ Inc., a calendar-year S corporation, revoked its S election effective Jan. 1, 2020. Once the S election is terminated (voluntarily or involuntarily), the corporation cannot make a new S election before its fifth tax year that begins after the first tax year for which the termination was effective. (The year ended Dec. 31, 2020, is the first tax year in which the termination was effective.) The tax year beginning Jan. 1, 2025, will be the fifth tax year beginning after the first tax year for which the termination was effective. Therefore, the earliest that XYZ can reelect S status without IRS permission is Jan. 1, 2025.
Example 2. Variation: Assume now that XYZ Inc. revoked its S election effective May 1, 2020. Here, the C corporation short-year period between May 1 and Dec. 31, 2020, is treated as the first tax year in which the termination was effective. The tax year beginning Jan. 1, 2025, will be the fifth tax year beginning after the first tax year for which the termination was effective. Therefore, XYZ can reelect S status on Jan. 1, 2025. If XYZ wanted to reelect S status before that date, it could request the IRS to waive the five-year period.
Exceptions to the five-year rule
The IRS has the authority to waive the five-year rule in certain situations. The corporation has the burden of establishing that under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than 50% of the stock in the corporation is owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted. In the absence of this fact, consent ordinarily is denied unless the corporation shows that the event causing termination was not reasonably within the control of the corporation or shareholders having a substantial interest in the corporation and was not part of a plan on the part of the corporation or those shareholders to terminate the election (Regs. Sec. 1.1362-5(a)).
This means that, if the corporation loses its S status because it inadvertently ceased to qualify as an S corporation or inadvertently violated the restriction on excess passive investment income, the IRS may allow it to retain S status upon establishing that the termination was unintentional, and the corporation and its shareholders have taken steps to correct the event within a reasonable period. The IRS, for example, waived the five-year rule when a depressed economy caused a company to have excess passive investment income (Rev. Rul. 78-275).
Requesting waiver of the five-year rule
An S corporation requests the IRS to waive the five-year rule or waive an inadvertent termination of the S election by applying for a letter ruling. A user fee must accompany the request.
Example 3. Reapplying for S corporation status (five-year rule): N Inc. is a calendar-year S corporation. During the current year, N’s controller discovers that passive investment income has been in excess of 25% of gross receipts for the past three years and that N has accumulated earnings and profits (AE&P) from prior years as a C corporation. As a result, N’s S corporation status terminated, and its last day as an S corporation was Dec. 31, 2019. This situation was due to an inadvertent error on the part of N and was corrected by distributing all of the AE&P to shareholders in April 2020. Does N have to wait five years to reapply as an S corporation?
The corporation’s first tax year for which the termination is effective (its first C year) is 2020. The fifth tax year that begins after that year is 2025. Thus, the five-year rule would ordinarily prevent the corporation from reelecting S status until the tax year beginning Jan. 1, 2025. However, the possible exceptions to the five-year waiting period rule include one for inadvertent termination. If the corporation loses its S corporation status because it inadvertently ceased to qualify as an S corporation or because it inadvertently violated the restriction on passive investment income, the IRS may allow retention of S status upon establishing that the termination was unintentional and the corporation and its shareholders have taken steps to correct the event within a reasonable period of time.
Another potential exception to the five-year rule occurs when more than 50% of the stock is owned by new shareholders.
Example 4. Reelecting S status when more than 50% of the stock is owned by new shareholders: G Inc., a calendar-year S corporation, revokes its S election on Jan. 1, 2020. Each of G’s five shareholders owns 100 shares of stock. In 2020, three shareholders sell all of their stock to an unrelated shareholder. Can G reelect S status after the new stockholders acquire their shares? The IRS would probably grant permission to reelect S status before the expiration of the five-year period because more than 50% of the stock in the corporation is owned by persons who did not own the stock at the time the S election terminated. To request the IRS’s permission, G must file a request for a letter ruling and remit the applicable user fee.
Automatic consent after certain terminations
A corporation may make a new S election before the five-year period expires, without the consent of the IRS, if the termination occurred because the corporation (Regs. Sec. 1.1362-5(c)):
Failed the eligibility tests on the first day for which its S election was to become effective.
Revoked its S election effective on the first day of the first tax year for which its election was to be effective.
Because the five-year waiting period does not apply under the preceding two circumstances, the S corporation is not required to file for a letter ruling or pay a user fee.
Successor corporation defined
The rule prohibiting an S corporation from reelecting S status for five years also applies to a “successor corporation” of the S corporation. A successor for these purposes is defined as any corporation whose election under Sec. 1362 has been terminated if (Regs. Sec. 1.1362-5(b)):
50% or more of the stock of the new corporation is owned, directly or indirectly, by the same persons who, on the date of the termination, owned 50% or more of the stock of the prior corporation whose S election terminated; and
Either the new corporation acquires a substantial portion of the assets of the prior corporation, or a substantial portion of the assets of the new corporation were assets of the prior corporation.
Example 5. Applying the five-year rule to a successor corporation: O Inc., a calendar-year S corporation, revokes its S election effective on Jan. 1, 2020. Each of O’s four shareholders owns 100 shares of stock. In 2020, three of the four O shareholders formed a new corporation, F Inc. Thereafter, they merged O into F and redeemed all of the stock owned by the fourth O shareholder. The three shareholders of F want to once again elect S status.
O is prohibited from reelecting S status until the tax year beginning on Jan. 1, 2025. The five-year rule also applies to F if it is the “successor corporation” ofO.
In this case, since the F shareholders owned 75% of the O stock at the time the S termination was effective, F is a successor to O and is subject to the five-year waiting period and cannot elect S status without IRS permission until Jan. 1, 2025. It is unlikely that the IRS would grant permission to reelect S status before that date because more than 50% of F’s stock is owned by persons who owned O’s stock at the time the S election terminated. (Note that if F were owned instead by persons unrelated to the O shareholders, F would not be a successor corporation and could immediately elect S status without IRS permission.)
This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 34th edition (March 2020), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).
Linda Markwood, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact [email protected]