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Jeremy Wells: In episode three, I talked about a few reasons why a tax professional might advise against an election, why an S corporation might not be a good fit for a lot of businesses out there. But what happens when a client has already [00:00:30] elected s for a business that probably shouldn't be an S corporation anymore, or in some cases never should have been an S corporation? Or what happens if the client decides that she doesn't want the administrative burden of an S corporation anymore, and wants her business to go back to being a sole proprietorship or a partnership again. We've actually dealt with this quite a bit recently in our firm. A lot of small businesses that started up during [00:01:00] the Covid 19 pandemic have seen business taper off quite a bit in the last year or two. And so businesses that a few years ago actually made sense to be s corporations nowadays not so much. And the owners want to stay in business, they want to keep operating, but it can be pretty burdensome to run an S corporation, especially when profit margins tend to not be what they were. Uh, when you first elected s once a corporation or other [00:01:30] entity makes a valid s election, that election remains in effect until termination. An S corporation can terminate that election in one of three ways. And in this episode, I'm going to break down these three different ways that an election can terminate, how to make those terminations and what some of the Implications of terminating an election could [00:02:00] be.
Jeremy Wells: So those three ways are to revoke the election. And I'll talk about a few different ways that that revocation can happen. The second way is it just ceases to be a qualifying small business corporation. That's the technical term for a corporation that has made an election. It is a small business corporation. And for those of you who work with s corporation owners and maybe you have an S corporation, you know that there are certain qualifications that a business needs to [00:02:30] meet in order to be an S corporation. Well, those qualifications have to be met continuously. It's not just meeting those qualifications, electing s and then not worrying about it anymore. Those qualifications have to be met continuously. And if the corporation ever stops qualifying to be a small business corporation, then that could trigger the termination of the s election and then a third way is honestly one I haven't seen much and I don't expect to see [00:03:00] very often. But it's important to keep in mind is a passive investment income exceeding a certain percentage of gross receipts? Basically, we want S corporations to be active businesses, not act as holding companies for passive investments. So we're going to talk about these three different ways that an S selection can terminate, and what some of the implications of those terminations could be. So let's start with termination by revocation. [00:03:30] What does it mean to revoke an S selection.
Jeremy Wells: Well, the same way that a business can elect to be treated as an S corporation, it can also change its mind and decide to revoke that selection. So an S corporation can revoke the s selection for any taxable year for the effective year of that election, including the first year, it's entirely possible for a business to elect [00:04:00] s and then within that first year, decide it wants to revoke. That's election. This is all, by the way, coming from IRC section 1362, section 1362. If you work with S corporations, 1362 is one of those code sections you need to know and along with the regulations that go with that code section, which are fairly lengthy, but 1362 is all about electing and terminating and selection. [00:04:30] So again, that's corporation can revoke the selection for any taxable year. A corporation can file a revocation statement with the same IRS service center where it properly filed the selection. That is the process for revoking an election. So this is why it's important to keep track of the [00:05:00] election. Whenever we elect s for a client of ours, we keep the 2553, the form 2553, which is the s election form. We also are looking for the confirmation letter that the IRS will send back to the corporation, letting it know that it has accepted the election. Now, in recent years, there have been some issues with some of those letters. Either it's taken a long [00:05:30] time for the IRS to process.
Jeremy Wells: That's election. I've seen it take anywhere from 6 to 18 months for that's election to get processed. Again, this is something that has to be paper filed, uh, the s election, because it needs wet ink signatures from all of the shareholders. Unfortunately, form 2553 is still one of the forms left that the IRS requires wet ink signatures. It will not accept electronic signatures, [00:06:00] so it's just impossible to file that form electronically. It has to be, uh, either mailed in or faxed in. But if you fax it, it still needs to be, uh, handwritten wet ink signatures, uh, on that form from all of the shareholders. When you get that acceptance letter back from IRS, keep track of that. And that will tell you the service center that processed that election. Then if the S Corporation wants to revoke [00:06:30] the selection, you send that statement back to that same service center that processed the selection. The statement has to include the total number of shares, including non-voting, uh, issued and outstanding at the time of the revocation and then the shareholders that represent at least one half of the issued and outstanding shares, including non-voting shares, have to consent to that revocation. So all of that needs to be included [00:07:00] with that statement that is being sent in. And that's coming from Treasury Regulation 1.1626. A each consenting shareholder consenting to the revocation also, uh, has to consent in writing to the revocation and include the shareholders name, address, tax ID, the number of shares owned and the date she acquired [00:07:30] that stock, the date that her taxable year ends, the name of the S corporation, the corporation's tax ID and the uh, election to revoke all of that has to be included in writing from every shareholder that is going to be part of that majority that is voting to revoke the election.
Jeremy Wells: Most of the time we're dealing with relatively small s corporations. [00:08:00] Most of our S corporations are single shareholders, so this would be relatively easy to fulfill that. But you could picture how an S corporation with more than a handful of shareholders this could this could potentially be difficult unless just a 1 or 2 of the shareholders controlled a majority of the stock. And in that case it would be relatively straightforward. But still all of that information has to be included, both for the corporation with the revocation statement [00:08:30] as well as from each of those shareholders in their written consent to the revocation. The corporation files that revocation statement by the 15th day of the third month of the taxable year. In general, if you're working with a calendar year's corporation, that's going to be March 15th. The revocation statement filed after that day is effective for the following tax year, and the corporation can specify a prospective [00:09:00] revocation date. So if you are looking forward and doing some tax planning and decide that the corporation wants to revoke that selection for the next year, then you could still go ahead and file that revocation statement and just mark that the revocation is going to be effective sometime in the next year.
Jeremy Wells: We will do this oftentimes, especially if we're more than about halfway through the year. And we have an S corporation that we know wants to revoke [00:09:30] its election, then we'll usually plan to go ahead and close out that year, that calendar year as an S corporation. But we'll go ahead and get the paperwork ready and send in that revocation statement and make it effective as of the beginning of the following year. However, if in the meantime, the corporation decides that it doesn't want to revoke the election, then it can actually rescind that revocation [00:10:00] by filing another statement with that same IRS service center where it properly filed the revocation statement. And again, this might be a good reason to use that prospective revocation to plan ahead for the revocation. Go ahead and get the paperwork together. And in the meantime, if you've already filed that revocation statement, you have some time to where if the shareholders change their minds, they want to keep the business as an S corporation, you would then have time to rescind [00:10:30] that revocation statement. And again, each shareholder consenting to the revocation, along with any new shareholders since the corporation filed the revocation, have to consent to the rescission. This is an interesting addition to the requirement here.
Jeremy Wells: So for the revocation you only needed the consent of the shareholders representing a majority of the stock of the corporation. If the shareholder, uh, if [00:11:00] any of the shareholders change in between the time that the revocation is filed and when the rescission would be filed, if the corporation adds any new shareholders in that time, the new shareholders also have to consent to the rescission. This you know, I can't imagine this happens very often. Uh, but I can also imagine a situation where you have an S corporation [00:11:30] that has a couple of shareholders, they decide to revoke the selection, and then maybe they bring on 1 or 2 more shareholders. In the meantime, and the new shareholders bring in some new business, or they're able to make some changes to the business that makes it run more efficiently or effectively. Whatever could change the nature of the business such that now revoking the selection [00:12:00] no longer makes sense. And in that case, the new shareholders, along with those who voted to revoke, might change their mind, decide to keep the selection. Again, I can't imagine this happening a lot, but it could be a possibility. And there is a clear process here in the regulations for being able to do that. Along with revocation, there is a special type [00:12:30] of revocation that is called a withdrawal. And I want to thank, uh, a mentor and friend of mine, Tom Gorzinski, for, uh, bringing this to the attention of me, along with a lot of other, uh, tax professionals.
Jeremy Wells: Uh, withdrawal is not in the IRC and it's not in the regulations, but it is in the Internal Revenue Manual. The Internal Revenue Manual, if you're not familiar [00:13:00] with it, is essentially the operating handbook within the Internal Revenue Service. The IRS is not authoritative. It's not tax law. However, it does provide a lot of information about how the IRS internally works, how it processes a lot of paperwork, and it does provide some rules on how the IRS will process different kinds [00:13:30] of, uh, things, different kinds of forms that you file, different kinds of things that you want the IRS to do on the taxpayer's behalf. One of them is this procedure of withdrawing an selection. So in this case an a business, a corporation has already filed a valid selection. And even if that election has already been accepted by the IRS, [00:14:00] the corporation can withdraw the election either by correspondence, meaning, uh, the corporation could write a letter, uh, and mail that or fax that into the IRS or by filing form 8832, which is the entity classification form. The corporation has to submit that withdrawal request by the due date of the initial s corporation tax return. So [00:14:30] again, if you're dealing with a calendar year's corporation, that's going to be March 15th of the following year. If the IRS accepts the withdrawal request, then the entity is treated as if the classification had never been elected.
Jeremy Wells: And again, this comes from the IRS. It's not in the code of the regs. It's in the IRS 3.1, 13 .2. 17.10. Excuse me, 27.10. [00:15:00] The IRS, citing the IRS is always fun because it's a lot of, um, it's basically a big outline. And, uh, the citations can get a little unwieldy. 3.1, 13 .2. 27.10 if you search the IRS for withdrawal, you should be able to find it. But the point here is, say you have a business that we're in 2025 now decides to elect, uh, [00:15:30] to be an S corporation for tax year 2025 so that election is effective January 1st, 2025. That's Corporation has to file its tax return by March 15th of 2026. If between now and March 15th of 2026, the corporation decides it doesn't want to be an S corporation, then it can either write into the IRS or it can use form [00:16:00] 8832 to withdraw the selection. And when the IRS accepts that withdrawal, then it will treat that business for the entire tax year 2025 as if the s election had never been made. Even if IRS has already accepted the S election, even if the corporation has already received that confirmation letter, it's still as if it never happened in the first place. This can be [00:16:30] a really great option for a taxpayer mistakenly electing s for a business that really shouldn't be, uh, an S corporation.
Jeremy Wells: We've done this before with small businesses that hadn't even really gotten started yet. Uh, the taxpayer got some bad advice online. Thought an S corporation starting off was the way to go. Did all the paperwork to get that. Uh. And then [00:17:00] now they're coming to us mid-year. It's still within the first year after the effective date of that election, but we're realizing that it really shouldn't be an S corporation yet. Or another situation where this happens is, again, bad advice, usually coming from somewhere online. The taxpayer thinks they need an S corporation for the LLC that they own some rental properties in. Generally that's not going to help. That's in fact that that could cause some potential [00:17:30] problems, and that's probably a good discussion for a future episode. On why we generally don't want rentals in a corporation or an S corporation. Um, but if we see that come in, then this is a way that we can, uh, withdraw that election without having to worry about going through the revocation process or deal with an unwanted s corporation. And it's important to note that withdrawal [00:18:00] is a type of revocation. It's think of it as a as an easy way of of getting a revocation. Uh, done. It is still a revocation, but it's a revocation that essentially wipes the slate. Clean it. It's as if the corporation never made the election. This can be important. Uh, for a point, I'll discuss, uh, toward the end of the episode, which is the five year rule.
Jeremy Wells: If a corporation elects S and then [00:18:30] revokes that election or terminates that election. Uh, then it can't elect S again within five years with a withdrawal, because the service treats that corporation as if it had never elected s in the first place. You don't have to worry about the five year rule that corporation could elect s withdraw its election, and then the next year decide to elect s again. And there's no problem with that. That's [00:19:00] all. Termination by revocation. Now the second type of termination is if the S corporation ceases to be a small business corporation. How could this happen? So an election terminates at any time on or after the first day of the tax year for which the election is effective. If the corporation ceases to be an S corporation. This is IRC section [00:19:30] 1362 D2. The corporation attaches a statement to its return, notifying the IRS that a termination has occurred along with the date of that termination. The election terminates on the date of a specific event, causing the corporation to fail to qualify as a small business corporation. A prospective election terminates on the day of that election. If the corporation does not qualify as [00:20:00] a small business corporation on the effective date of the election. Let's think about what this would look like. Let's say a corporation or a business selects s, uh, effective January 1st of the following year.
Jeremy Wells: In the meantime, so this is a prospective election. In the meantime, that business, uh, Uh, does something that causes it to no longer [00:20:30] qualify to be an S corporation, and that's still true as of that perspective. Elections effective date the beginning of next year. In this case, on that date, the selection is effective, but then it is also immediately terminated due to the ineligibility of the corporation to be an S corporation. If a corporation ceases to be an eligible corporation, then it ceases to [00:21:00] be an S corporation. Uh, this occurs when, uh, any of the following things can happen. And as you're listening to this list, the a lot of these should just seem like standard, uh, qualifications for electing s, and that's because they are, uh, so, first of all, a financial institution that uses the reserve method of accounting for bad debts. Well, honestly, [00:21:30] I've never dealt with a company that does that, but that is one of the kinds of companies, one of the kinds of institutions that can't elect, uh, an S corporation, a foreign sales corporation, or a domestic international sales corporation or a disk, um, as they're commonly known. These are, uh, a specific type of, uh, corporations that essentially have to do with promoting, uh, development, especially in the Caribbean [00:22:00] area. So, uh, Puerto Rico, uh, in particular. Again, I haven't worked with these, but these are, uh, automatically not eligible to be s corporations. Any insurance company that's subject to tax under subchapter L of the IRC cannot be an S corporation.
Jeremy Wells: Now those are those are kind of weird, honestly. Um, you know, those aren't. We don't get a lot of clients in our firm. Really? Any that would fail on those. But here's where [00:22:30] we start to get into some of the more, uh, basic qualities of an S corporation. Uh, that could disqualify a corporation from becoming an S corporation. The first one is the 100 shareholder limit. So if the corporation has more than 100 shareholders, it cannot be a small business corporation. Therefore, the s election terminates. Again, most of the S corporations we work with have one, maybe 2 or [00:23:00] 3 shareholders. We generally don't work with large S corporations, meaning lots and lots of shareholders. It's it would be incredibly unwieldy. We'd probably prefer a partnership and a lot of these cases for various reasons. But let's just say you do have an S corporation that has 90 something shareholders in it, and it makes a prospective election. And in the meantime, a few more shareholders get added to [00:23:30] where now it has over 100 shareholders. That would be a problem that would disqualify that corporation from being, uh, a s corporation. Of course, the number of shareholders matters, but also the kinds of shareholders. So if the corporation has a shareholder that is not an individual other than a few particular cases where the shareholder might be in a state trust or certain kinds of tax exempt [00:24:00] organizations, in general, an S corporation shareholder has to be a resident individual, uh, of the US.
Jeremy Wells: If there's a shareholder that is not that typically that disqualifies the entire S corporation, the entire corporation from being an S corporation. You can think of cases where this could easily happen, uh, where a prospective s selection is made. In the meantime, another [00:24:30] partner is added, and it's not until too late that somebody asks for some more information about this new shareholder. And come to find out, this new shareholder is not a qualifying shareholder. Uh, for an S corporation. There are also cases where you will have a shareholder, uh, die. And then we now have to look at whether that, uh, that deceased shareholders, uh, [00:25:00] trust or estate qualifies to be a shareholder of the S Corporation. And what that could do to the selection, uh, their tax court cases dealing with situations like this where we've got an inadvertent termination of the election, uh, and asking if there's any kind of relief for that, uh, for the beneficiaries of that estate or trust. Of course, the corporation, if the corporation has a nonresident alien as a shareholder, that will blow the [00:25:30] s election. And then if the corporation has more than one class of stock. Now, this is, uh, a concept that I see misinterpreted, uh, and I and I hear discussion of this concept, uh, being misinterpreted in a lot of places.
Jeremy Wells: But when we talk about more than one class of stock in an S corporation, there are two things to keep in mind. One is that voting [00:26:00] versus non-voting stock does not create a second class. You can have voting and non-voting stock in an S corporation. We don't get into advising on the actual governance structure Within corporations and businesses very much. One, we're not attorneys. And two, again, most of our clients are relatively simple. There's one, maybe two shareholders, so there's just not much there. But we've had some cases [00:26:30] and I've worked with some corporations where say they want to bring on an employee as a shareholder, they want to offer some equity to an employee. You might want to structure that equity compensation for the employee in such a way that the employee is given some equity, but it's non-voting because you want to reward them with, uh, a bit of, uh, ability to profit off of the business, [00:27:00] to incentivize them to care more about the business and work harder for the business. But you don't necessarily want to get them involved in the actual management and leadership of the business, at least not yet. So maybe you structure this equity compensation in such a way that for the first year or two, it's a certain percentage of the stock, but it's non-voting stock. And then maybe after some time that will convert into some voting stock. That's all perfectly fine [00:27:30] within an S corporation.
Jeremy Wells: It's perfectly fine to have voting and non-voting stock in an S corporation where you run into trouble. And this often happens with partnerships with with multi-member LLCs that are treated as partnerships that uh elect s is you have uh, certain uh, membership units within that LLC who now become shareholders in the S Corporation. And based [00:28:00] on the operating agreement, they have different rights to distribution and liquidation proceeds based on the operating agreement. This could be the result of contributing different amounts at the formation of the company. It could be the result of equity, compensation and earning that at different times. And so the operating agreement gives some members of the LLC, now shareholders, the corporation gives some of them different rights or preferential rights [00:28:30] to distributions and liquidation proceeds. We're going to give preference to the earlier investors, for example. That might be one way to do it. Or similar to the way a C corporation might have common stock versus preferred stock, where the preferred stockholders will get their distributions, their dividends first. So if there is any profit to distribute, preferred shareholders get their dividends first. And then if there's [00:29:00] anything left over, the common stockholders will get dividends. It's entirely possible to do the same thing in a partnership. Um, and there are lots of different ways to structure this, but it's possible to make it to where some members will get distributions first. And then looking at the math, if there's anything left over, then other members will be able to get some of those remaining profits distributed to them.
Jeremy Wells: That is not allowed in an S corporation [00:29:30] and an S corporation, every share of the corporation stock has to confer identical rights to distributions and AI and liquidation proceeds to every other share of stock. So if I own 10% of the stock, I get 10% of the distribution. If somebody else owns 20% of the stock, they get 20% of the distributions. Now, in general, we talk about it being a problem. [00:30:00] If a if an S corporation has non pro rata distributions at the end, it's the end of the year. We're getting ready to prepare the tax return. We look at the balance sheet and we see that one shareholder got some more distributions than they should have. And a couple other shareholders got not as much distributions as they should have. We can correct that. It's not necessarily going to blow the election if we have an isolated event of non pro-rata distributions. And there are tax court [00:30:30] cases showing that the the non pro-rata distributions are not what causes problem for the election. It's when we have different shares that have different preferential rights to those distributions. And as long as we don't have that in the S corporation then the S election is is fine. And again there are there are several tax court cases that have looked at this question. And that's where we [00:31:00] keep coming back to makes it incredibly important.
Jeremy Wells: If you're working with an LLC that's considering electing as it's incredibly important to get a copy of the operating agreement and review that and make sure that there are no preferential rights, no waterfall distribution schedules, that sort of thing, to make sure that if that LLC elects s every shareholder based on the number of shares they have, has an equal right to the distribution [00:31:30] and liquidation proceeds, as every other shareholder, at least on a per share basis. So that's all how termination by ceasing to be a small business corporation could work. In other words, if the corporation does something that just blows the s election, that just makes it not eligible to be an S corporation anymore. There is a third, uh, weird case. I've not had to deal with this personally, thankfully. Uh, but, uh, I, I've come [00:32:00] close. I've had I've worked with a couple of s corporations where the taxpayers really did not know what they were doing when they set up the S Corporation. Of course they did it on their own. They did it based on some, uh, either some misinterpreted advice or some bad advice they picked up from somewhere online. But, uh, they made a, an LLC that was holding some personal investments, an S corporation. [00:32:30] And at first I thought this was going to be a problem. It turns out it's not good, of course, but it wasn't the problem that I thought it was going to be.
Jeremy Wells: This is a termination due to excessive passive passive investment income. But this only kicks in when you have an S corporation that had a period of being a C corporation. [00:33:00] So if a corporation is a C corporation and has earnings and profits for, uh, three consecutive tax years as an S corporation. And for each of those tax years has passive investment income exceeding 25% of its gross receipts. Then that's corporation's election terminates. Okay, let's [00:33:30] back up a little bit. What is this? What does this look like? If you have a corporation that is a C corporation. And a C corporation now has earnings and profits, it has retained earnings basically. And then it elects s. And now as an s corporation for at least three consecutive tax years. Those C corporation earnings and profits are [00:34:00] still on the books for that's corporation. They're still there in the M2, but that's corporation has passive investment income that exceeds 25% of its gross receipts. Then that selection automatically terminates. This is all from IRC section 1360 2D3. The idea here is that Congress intended to make S Corporation [00:34:30] provisions available only for businesses that are engaged in active operations of businesses, not those that are mainly involved in passive investment activities. So we want s corporations to hold active businesses. We don't want them to hold passive investments now, because a lot of S corporations today are LLCs [00:35:00] That then elected s and never had a period of being a C corporation.
Jeremy Wells: For the most part, a lot of them just are not going to have any C corporation earnings and profits on the books. And in that case, this particular way of terminating is never really going to going to get triggered. However, it's important to keep that in mind [00:35:30] if you're dealing with any kind of entity, especially a corporation that does elect s in general, though, we just want to avoid for various reasons. We want to avoid passive investments inside of s corporations. Again, the entire you know, the main point of an S corporation is to reduce the, uh, self-employment or payroll tax Liability is [00:36:00] a passive investment. Activity generally is not subject to self-employment or payroll tax. So what's the point? Also, you're going to run into the problem of uh, you're going to have to distribute those, uh, appreciated capital assets to the shareholders in order to get anything, uh, out of them. And most shareholders are not going to enjoy seeing that, uh, [00:36:30] when it passes through to them. So in general, we want to avoid that. However, if you've got an S corporation that never had any period of being a C corporation, then this probably isn't going to, uh, make any difference. The effective date of the termination due to excessive passive investment income, uh, is the first day of the first tax year following that third consecutive year of excessive passive investment [00:37:00] income.
Jeremy Wells: So you notice that you've got three straight years of excessive passive investment income. The first day of the following year is the effective date of the termination of that selection. In terms of this way of terminating selection, the the gross receipts means the total amount received or accrued, uh, depending on which uh method, [00:37:30] which method of accounting, which basis, whether cash or accrual that the business uses. Uh under the corporations method of accounting used to compute taxable income not reduced by returns and allowances, cost of goods sold or any deductions. So we're just looking at top line line one gross receipts. And if passive investment income exceeds 25% of that amount. In [00:38:00] that case, then that's that's excessive gross receipts from the sales or exchange of capital assets other than stock and securities are taken into account only to the extent of capital gain. Net income. This is IRC 1362 D3B1. So we do take into account the capital gain from the sale of capital assets, but only to the extent of that net [00:38:30] income. So we're going to net the capital gains and losses. So if we've got a lot of stock transactions for example, we're going to net all of that now other than uh stock and securities when we're talking about sale of capital assets here. So let's say we've got a lot of assets on the books, and the business sells a bunch of them that are not stocks or securities, and the business sells a bunch of them.
Jeremy Wells: We're going to look at the net capital gain from [00:39:00] all of those sales for, uh, sales or exchanges of stock or securities. Uh, then we're only going to look at the gains from selling them for purposes of computing gross receipts from sales or exchanges, stock or securities losses do not offset gains. Important to keep in mind if you have an S corporation that is holding a lot of stock investments. I [00:39:30] had a client one time that did this. The individual thought he needed to put his individual trading, uh, his individual stock holdings into an LLC and then for some reason thought he needed to elect S for that LLC. Now he's got an S corporation that just holds a few brokerage accounts that are trading stocks, earning dividends and some interest. Nothing but passive [00:40:00] income. And so this is one of those cases that made me curious as to whether this particular, uh, part of the code was going to trigger a termination of that selection. Well, that LLC went straight from registration to being, uh, elected. S and so there was never a period of any C corporation activity. There was no C corporation earnings and profits. So nothing to worry about there. [00:40:30] Passive investment for these purposes includes royalties, rents, dividends, interest and annuities that are not earned in the ordinary, uh, trade or business. That's important to keep in mind as well.
Jeremy Wells: So when we talk about rent in particular and then also interest, we're not talking about activities that [00:41:00] are actually the main trade or business of this entity. We're talking about that kind of income that might be passing through into the S corporation. Um, or that the type of income that is passively earned by the corporation. It's important to keep in mind here that even though I'm using the term passive, uh, income, and that is the term from code section 1362, this [00:41:30] is a completely independent concept, and the rules are completely independent from those of section 469. Now, section 469 is all about the passive loss rules. And when a taxpayer can or can't offset uh, Their active or non passive income with passive losses. There's a whole lot uh to code section for 69 and [00:42:00] its regulations as to what we mean by passive income. Passive losses passive activities. That is a completely separate and independent concept and discussion and set of rules from what we're talking about here with 1362. There is some overlap. No doubt. Uh, and a lot of the things that are passive income for section 469 are also passive income [00:42:30] for 1362, but they are completely separate rules. So if you're looking at some income for the purposes of wondering whether the passive losses that could be taken against active income, for example, don't look at 1362. Just look at 469. On the other hand, if you've got an S corporation that might have excess passive investment income in it, don't look at 469 in its regulations.
Jeremy Wells: Just focus on 1362 royalties. [00:43:00] In this case, don't include those derived in the ordinary course of a trade or business of franchising or licensing property. So for example, if you have an artist or an author or you have a corporation that is franchising out its business model, any royalties earned through those activities generally are not going to be passive income for these purposes. That's the normal trade and business of that entity. Rents don't include [00:43:30] those derived in the ordinary course of a trade or business of renting property. So earlier I said we generally don't want investment income, such as rental properties inside of an S corporation. While that's still true in this case, if we're talking about an S corporation that actively operates rentals, not just earns pass through rental income from its investments, but rather owns and operates rental properties. In that case, that's not [00:44:00] going to count as passive investment income for purposes of section 1362. Note that it would still be because it's rental unless it's a short term rental. If it's a long term rental, it would still be passive investment income for purposes of section 469, but not necessarily for section 1362. So that's a good example of why those two code sections are completely separate. They're independent from one another, and you have to look at the activity separately [00:44:30] for the purposes of each of these code sections.
Jeremy Wells: If the corporation performs significant services or incur substantial costs in the rental business, then it's not Passive that rental income is not passive for purposes of section 1362. Now, whether the corporation performs those significant services or incurs substantial costs is determined based upon all the facts and circumstances, including, but not [00:45:00] necessarily limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred other than depreciation. And this comes out of the regulations 1.13 60 22C in other words, if we're looking at the rental activity in the corporation, just ignore depreciation because that's usually a pretty significant expense for a rental activity. [00:45:30] But if we're trying to determine whether that is passive investment income or whether it's normal trade or business income for an S corporation, we're basically going to be looking at who does the S Corporation employ to run and manage those rentals? And is the corporation bearing a significant cost or a portion of the cost in managing and maintaining those rentals? If [00:46:00] the payer receives a service and the use of property is just merely instrumental, then the payment is not for the use of the property or rights and is not classified as rent. This comes out of revenue ruling 81 197. This could actually be important if we're thinking about corporations that are typically [00:46:30] both providing a service and also renting equipment along with that service, for example.
Jeremy Wells: So think about the event planning businesses. A lot of them will have equipment. They might have photography or videography equipment. They might have the canopies or the tents that they set up. They might bring along some small vehicles that they could use to run around the [00:47:00] event location. For example, there might be a lot of different, uh, pieces of property that are included along with the services provided, and you might even see invoices that would separately list equipment rental, for example. So with an event planning business, you might see on the invoice the rental of the tent, uh, in which the event is hosted, you might [00:47:30] see rental of the lighting equipment, for example, or the sound equipment, all of that if it's Included with the service of setting up, taking down, running, managing, overseeing the actual event itself. That's all a service then. In that case, we're not going to separately consider the rental income as potentially passive investment income. Really, it's just part of [00:48:00] the the entire service that's provided. The example I actually given in the revenue ruling is of an aircraft that's leased to passengers on an annual basis, but the corporation that owns the aircraft also employs the pilot for the aircraft. In that case, the pilot is according to the IRS and this revenue ruling, the pilot quote, has primary authority for the safety and actual operation of [00:48:30] the aircraft. And in this case, even though that aircraft is being leased to the customer, the corporation is maintaining ownership and control of that equipment.
Jeremy Wells: And so it's not really passive rental income. The service of providing transportation to the lessee is what's really being sold there. And then in revenue ruling 6591, the IRS determined that an S corporation that owned and operated a parking [00:49:00] lot did not collect rent because it employed the attendant that worked the parking lot and actually parked the vehicles. So that might be an important distinction. If you've got an S corporation that owns a piece of real property that is being actively used, in this case, a parking lot, it might make an important distinction as to whether the corporation employs anyone to oversee, [00:49:30] maintain, manage on a day to day basis. That property, in this case the attendant not only oversaw the parking lot, but actually parked the vehicles. It might be interesting to look at a case where the attendant merely just sat in the office and watched the parking lot, and maybe monitored the security system, but, uh, drivers parked their own vehicles, and it'd be interesting to see whether the IRS would rule similarly on a case like that. And [00:50:00] then dividends from a C corporation, of which the S Corporation owns 80% of the stock in both voting power and value, uh, are not included in computing passive investment income. So if the S Corporation owns a controlling interest 80% or more of a C corporation, then those dividends are not passive investment income.
Jeremy Wells: You can also have an administrative dissolution. Uh, and this is a case where the [00:50:30] state government dissolves the entity that elected S. This happens all the time. An LLC is registered in a state. The owners forget to renew the registration after the first or second year. The state administratively dissolves the LLC. What does that mean at the federal level? The IRS has, uh, multiple, uh, [00:51:00] pillars, uh, private letter rulings showing that the IRS still considers the S corporation in existence. So a state law administrative dissolution of an LLC does not translate into a termination of the selection. That selection is still effective. So there was a case where the the S corporation [00:51:30] continued to act as a corporation. It stayed in business. It kept operating. It kept filing its tax returns. And in those cases, the IRS continued to treat it as an S corporation despite the administrative dissolution under state law. And another, uh, peeler, uh, ruled that there is no need for a new selection for a corporation that [00:52:00] was administratively dissolved and then subsequently reinstated. So this actually happens quite a bit. And if you've got a client in this case, uh, just know that at least at the federal level, all is good. As long as the business continues operating, continues fulfilling its tax filing requirements, the IRS seems to not really care about what happens at the state level. Now. Obviously, it would be in the taxpayers [00:52:30] best interest to get things squared away at the state level.
Jeremy Wells: Uh, renew the registration of the LLC on time. Or if they do miss it, to reinstate the LLC. Obviously, that would be the best thing to happen at the state level. However, if you've got an LLC that's administratively dissolved or a corporation that's administratively dissolved and it's an S corporation for federal tax purposes, just keep operating as if everything is fine, at least at the federal level, and try to get [00:53:00] that corporation or LLC reinstated at the state level. I'm going to pause at this point, because I want to give some time to thinking about what's going to happen, uh, in the year of termination for the S Corporation. I also want to look at what can happen with an inadvertent termination and some of the relief that IRS offers for that. And as I said at the top [00:53:30] of the show, want to get into the implications of what terminating an election looks like. So to wrap up, we this episode, this will end up being a two part episode. In this first part, we talked about the three different ways that an S corporation could terminate its election revocation by failing to qualify as a small business corporation, or by the passive excessive passive investment income. Those [00:54:00] are the three ways that an election can terminate. Going to come back in part two and talk about what next? What happens then? How do we deal with the fallout of a terminated s selection, and where do we go from there?