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Jeremy Wells: Welcome back to part two here of talking about ending an S Corporation. So if you remember from part one or if you haven't listened to part one, I definitely recommend going back and listening to that first. But in part one, I started off by referencing episode three of this podcast, [00:00:30] in which I discussed a few reasons why a tax professional should advise against an election. However, a lot of times we don't have control over whether our clients have s corporations or not. They come to us and they've either set them up themselves, or they've been advised by another practitioner to have an S corporation. Or maybe they had an S corporation that was working fine and for whatever reason, that's [00:01:00] corporation is no longer the best entity type for that activity. That could happen for several reasons, but in the prior episode, I talked about a few reasons. A few ways that we can wind up with a terminated s selection that is essentially in the IRS's eyes, what ends an S corporation? Whenever we have an entity that has made that selection, the first [00:01:30] step of ending that's corporation is to terminate the election. So to briefly review, we went over three ways that that termination can happen. The first way is termination by revocation. Revocation is where the shareholders and the corporation essentially let the IRS know that they no longer want that entity to be treated [00:02:00] as an S corporation. And so they revoke the selection.
Jeremy Wells: And there are rules that I covered in that episode about how to make that that revocation and what that entails and what's required in order to make that revocation. There's also a special type of revocation called a withdrawal. And withdrawal can be really helpful, especially if you've got a situation where a taxpayer [00:02:30] recently elected s for an entity that really should not be an S corporation. A lot of times this will happen where the taxpayer comes to us, they sign up as a new client and part of the discovery or onboarding results in us finding out that they have an LLC and they've already sent in the election paperwork. And we're looking at the business, we're asking questions, we're getting information from the shareholder [00:03:00] taxpayer, and we're realizing that it really it really should not be an S corporation for some of the reasons that I mentioned in episode three. Um, or maybe just because the entity just simply just doesn't have the economic need to be an S corporation. And so we're going to recommend that they withdraw that election as long as we can do that timely. So that's the that's the first way to terminate an election is revocation or withdrawal. The second [00:03:30] way is if the corporation ceases to be a small business corporation. In other words, if it just fails to meet the specifications and the requirements for being an eligible S corporation. And there are the various rules of what it takes to be an S corporation who can be a shareholder in an S corporation.
Jeremy Wells: How many shareholders an S corporation can have, and rules about the way [00:04:00] an S corporation can operate. And in particular, if it's an LLC that elected S, then what can be in that's corporation's operating agreement. And this makes it really important for tax professionals to look at and read the operating agreements of the LLCs that they work with and advise, especially if they're going to make s elections, because we need to make sure that that operating agreement is free of any language that's going to cause problems for that [00:04:30] selection. In particular, if there are any rules about how allocations or especially distributions are going to be made that work under subchapter K, the part of the Internal Revenue Code that governs partnerships but that aren't allowed under subchapter S, the part of the Revenue Internal Revenue Code that deals with s corporations, then we need to make sure that that language is either removed from the operating agreement, or that the operating agreement is amended [00:05:00] to either replace or add on language that is going to work under subchapter S. So if the entity is no longer qualifying to be an S corporation, then it ceases to be a small business corporation. And that terminates the election. And then the third way that an S corporation's election can be terminated is due to excessive passive investment income. Discuss [00:05:30] this on the previous episode.
Jeremy Wells: There's a lot of rules and nuance here. For the most part, this isn't really relevant to a lot of the S corporations, for example, that I work with, and that I would imagine most other small accounting firms are working with for a couple reasons. One, uh, most s As corporations have not been C corporations for a while before they became S corporations. Most entities that we're working with today are LLCs. And those LLCs are generally [00:06:00] treated as either sole proprietorships or as partnerships before they make the S election. So there's usually no period of being a C corporation during which they would have accumulated earnings and profits. That's really part of the issue with a s corporation that, uh, is that has an issue with excessive passive investment income. And that's really the second, uh, [00:06:30] reason that we don't see this a lot. Most s corporations are created, uh, because we have ordinary income coming through and the, uh, the owner or owners, uh, would have that income subject self-employment tax, whether it was a sole proprietorship or a partnership. And so they're looking to save on self-employment tax with that selection that uh, is not [00:07:00] passive investment income. So in general, we're not going to see a lot of cases where we have, uh, an S corporation that has a period of being a C corporation and therefore has accumulated earnings and profits, and then, uh, has excessive passive investment income. It's entirely possible, though, and it's something to look out for, uh, with your s corporations.
Jeremy Wells: So if you're advising s corporations that do have a period of being a C corporation and therefore [00:07:30] have some accumulated earnings and profits, you need to very carefully look at what kind of activities are going on in that's corporation, what kind of income that's corporation is making, if it is passive investment income, if it's interest, dividends, that sort of thing, then we need to be careful and make sure that we're not running the risk of having that selection terminated due to excessive passive investment income. Those are the three ways [00:08:00] that the selection can be terminated. Um, and then we also discuss briefly, uh, something that comes up every now and then, uh, in my firm at least. And I see other practitioners asking about this is administrative dissolutions at the state level. So what happens if an LLC that elects s or it could be a corporation, an Inc, uh, that has elected s? What happens if that entity is dissolved at [00:08:30] the state level? Uh, a lot of times this happens administratively because the entity fails to file its annual report with the state's secretary of state office or division of corporations or whatever that particular state calls it. Um, I'm in Florida. It's called the division of corporations within the Secretary of State's office. And a lot of times, uh, LLCs will get registered by their owners. [00:09:00] They might, uh, make some tax selections, such as an election.
Jeremy Wells: They might have some activities. They might even file some tax returns. But then someone forgets to file the annual report, or the business winds down and no one thinks to actually shut the registration down with the state. And so the, uh, annual reports are never filed. And then you've got a situation where that entity, uh, is has [00:09:30] not updated its registration. It has not filed its annual report. And in that case, the state might administratively dissolve the registration. Uh, I know in the state of Florida, uh, this can get particularly expensive if you forget to file your LLCs annual renewal, for example. Uh, the normal annual fee to renew, uh, an LLC is something like $138. [00:10:00] However, uh, that is due by May 1st of the year. And if you miss that, if you file it on May 2nd or any day after that, uh, then I think there's about a $400 penalty that's attached to that as well. So you just went from about $138 to I think it's now $538. And, and that accumulates over time. And so most LLC owners, especially [00:10:30] if they're not really interested in maintaining that entity's registration, keeping it up to date anymore, they're never going to pay that extra amount in order to renew that LLC. So what you wind up with is a lot of administratively dissolved entities. Now, what can be a really interesting question from a tax perspective is what happens if you have an LLC that has uh, had its uh, has made its s corporation, uh, election, but [00:11:00] the entity itself, for whatever reason, uh, was administratively dissolved at the state level.
Jeremy Wells: Well, as far as the IRS is concerned, and because the s election is a federal tax election, it has nothing to do with the state tax entity. Uh, the state legal entity. It's just a, uh, the the election is just a federal tax election. It has nothing to do with the state legal entity. So as far as the IRS is concerned, that's election is still in place, even if the underlying state legal [00:11:30] entity has been dissolved. So if that's corporation continues to act as a corporation and fulfills its federal tax filing obligation, then the IRS continues to treat it as an S corporation despite that administrative dissolution under state law. Um, and that's actually from a private letter ruling. There's another PLR that says that, uh, if the entity then [00:12:00] subsequently renews, uh, or reinstates its registration after being administratively dissolved, then that's election is still valid. There is no need for the entity, uh, to do a new election, as long as it's the same entity and it's reinstated at the state level. That selection is unaffected by all of that. And both of these are coming from polls. So even though this isn't, uh, authoritative generally polls, it does [00:12:30] give us an idea of how the IRS thinks about selections and their interaction with that state legal entity.
Jeremy Wells: Administrative dissolutions, it seems in the IRS's eyes, don't really have an effect as long as that that entity, uh, despite, uh, not keeping up with its state filing obligations, as long as it keeps up with its federal filing obligations, the IRS, uh, is fine to continue treating that entity as an S corporation. [00:13:00] So those are all the different ways that an selection could terminate, or in the case of an administrative dissolution, doesn't necessarily terminate. In this episode, though, I want to pick up the discussion and think about what happened after, uh, that termination. So first of all, let's look at what happens if we didn't want that termination. Now, again, those, uh, ways of the election being terminated, [00:13:30] one of them is, uh, Truly the up to the corporation or the shareholders. If it's a termination by revocation, that is the shareholders agreeing that we no longer want this entity treated as an S corporation. However, uh, the the other two types of termination, termination by ceasing to be a small business corporation, especially, uh, or termination due to excessive passive investment income. [00:14:00] Uh, those might be inadvertent. In fact, there are lots of cases where you have an inadvertent termination, uh, due to ceasing to be a small business, uh, corporation. It's entirely possible to think of some, uh, pretty easy scenarios where you would have an S corporation that inadvertently, uh, terminates due to failing to [00:14:30] meet the criteria to be a small business corporation.
Jeremy Wells: So for example, one of the main criteria for an S corporation is that all of the shareholders are eligible individuals that could easily be violated if one of the shareholders sells her interest to an ineligible shareholder. [00:15:00] So imagine one of the shareholders sells her interest to a corporation. A corporation cannot be an S corporation shareholder. So in that case, the corporation now has an ineligible shareholder that causes a termination of the selection. Uh, imagine that the corporation, uh, already has 100 shareholders. [00:15:30] Uh, that's the limit for an S corporation. And there are some exceptions to those limits. For example, a married couple counts as one shareholder in counting toward that 100 shareholder limit. But imagine that the corporation has exactly 100 shareholders. And then one of those shareholders sells her interest to two or more individuals. Those individuals could be eligible shareholders. But because she sold her [00:16:00] interest to more than one individual, the total number of shareholders now exceeds 100. That would make that entity ineligible to be a small business corporation, and therefore its selection would terminate. Now, I don't work with any S corporations that have anywhere close to 100 shareholders, if anything. Uh, most S corporations have one, maybe a handful of shareholders. Uh, there might be some S corporations out there [00:16:30] that have close to 100 shareholders. But I think statistically that's pretty rare. Uh, the overwhelming majority of S corporations have fewer than ten shareholders.
Jeremy Wells: But it's entirely possible, right? Uh, that you have an S corporation with more shareholders than that. That might run afoul of that requirement. It's entirely possible that the S Corporation violates [00:17:00] the, uh, one of the most important rules of being an S corporation, which is the one class of stock rule. And that's really, uh, a very easy situation. And it's a relatively common situation that happens with s corporations. I mentioned a few minutes ago that when we have an LLC that elects to be an S corporation or wants to be. We need to very carefully read that LLC's [00:17:30] operating agreement, the operating agreement is the contract among the members of the LLC, uh, and the LLC itself that gives definition to the uh, organization that explains how it's going to operate. Part of that is in terms of the internal decision making. But part of that is also in terms of the tax treatment of various transactions within the LLC. Now, the default [00:18:00] treatment tax treatment for a multi-member LLC is as a partnership. So that's talking about subchapter K. And there is greater flexibility in how a partnership can treat its partners and make taxable transactions or, uh, important transactions for tax purposes, uh, happen inside the partnership. One of those is distributions. A partnership is [00:18:30] free. Um, mostly free, uh, to distribute its cash and other assets to the partners as it sees fit. And a lot of times LLC operating agreements, uh, will use that kind of language to the point at which partnerships uh LLC, acting as partnerships, will create some relatively sophisticated and complicated ways of calculating distributions to different [00:19:00] members, especially if some of those members are, uh, investors into the activity that aren't involved in the day to day operations.
Jeremy Wells: This is a pretty typical with private equity or relatively large real estate partnerships, and we might wind up with a system where distributions Solutions are calculated such that certain investors are incentivized [00:19:30] and therefore rewarded uh, before other investors are or before other LLC members are. In other words, some investors get into these LLCs because they want to get a return on their investment. They're not interested in actually building up the business. They're not working in the day to day operations. They're merely putting money in and expecting a return on that investment. And the way they get that return is through distributions back out of the LLC. So they want their distributions [00:20:00] before really anybody else gets theirs. So there might be rules set up in the operating agreement that make that happen. The problem with that in an S corporation, though, is that the way we define a single class of stock for an S corporation is in terms of rights to the distributions and especially the liquidating distributions of [00:20:30] that entity. So if we create a system in the operating agreement where some members or shareholders are going to get their distributions first, or they're going to get more distributions than other members relative to their actual ownership of the entity.
Jeremy Wells: Well, then we have by default created at least one extra, if not several more classes of stock, with this thing being an S corporation. So that can that can create [00:21:00] problems for the S corporation. And in fact, uh, a lot of what the IRS does, uh, when it comes to, uh, dealing with inadvertent selections is deal with cases where the operating agreements have created situations where the S Corporation could not abide by the one class of stock rule, because the operating [00:21:30] agreement dictated that distributions needed to go a certain way. There was a recent tax court case, Maggard v Commissioner. This is a Tax Court memorandum 20 2477. In that case, uh, what actually happened was the operating agreement didn't, uh, create a system where distributions were, uh, creating a second class of stock. What actually happened was the, uh, [00:22:00] the petitioner in this case was trying to convince the court that the corporation had created a second class of stock because the petitioner, uh, was essentially getting treated unfairly by the other shareholders in the corporation. The petitioner was left out of the distributions. The other shareholders. The other two shareholders, they were taking their distributions. They were getting cash flow out of the corporation. Magadh was not and Magadh [00:22:30] wasn't happy about that. The problem is the K1's were still showing income going to Magadh. Magadh was still getting, uh, the share of the S Corporation's income reported on the K-1, but was not getting any cash distributions out of the corporation.
Jeremy Wells: Obviously the problem there is you've got taxable income, but you've got no cash out of the corporation to pay it. What [00:23:00] Magadh tried to convince the Tax court was that this created a second class of stock. However, the Tax Court disagreed and said, well, actually there's nothing in the operating rules of the entity saying that certain shareholders will get distributions before other shareholders. The Tax Court actually ignored the fact that there were non pro-rata [00:23:30] distributions happening, and instead looked at what the governing documents of the entity actually said should happen. So there's a difference here between a shareholder not getting the cash that they should out of the corporation in terms of distributions and the governing documents of the corporation, actually creating a system where certain shareholders will get differential, uh, benefits [00:24:00] in terms of distributions than other shareholders. That's not allowed. You can't create a system where certain shareholders benefit more than others. But if you just make non non-Pro rata distributions, but not because the operating agreement told you to. Just because you haven't moved the cash around the way you should, that doesn't necessarily lead to a termination of the selection. And that's what we get from the tax court. And [00:24:30] this is also what the Treasury Regulations 1.1 611L uh, tell us, is that really it's based on what the governing document, what the operating agreement, uh, of that entity tell us should happen.
Jeremy Wells: And if they tell us that the distributions should be given on a non pro-rata basis, then we have multiple classes of stock. Just because we have non pro rata distributions [00:25:00] doesn't necessarily mean that we violated the one class of stock rule. It might be an indicator that the corporation has but it's not necessarily Determinative. Um, and so we need to make sure that we're clear with the operating agreement on how distributions are going to be made. It's also important to keep in mind that non-voting stock does not count as a separate class. Again, the definition, at least in core [00:25:30] according to the Treasury Regulations and the Tax Court, the definition of a second class of stock is unequal rights to distributions and liquidating distributions. It has nothing to do with voting rights. So you can have voting and non-voting shareholders in an S corporation. You just can't differentiate their rights to distributions based on whether they vote or not. There's also a trend, [00:26:00] especially among private equity, uh entities to and and and lots of of of medium sized businesses. I don't see this as much in small businesses, although some small businesses want to try to find ways to incentivize their employees other than just increasing their salary or arranging what can be relatively expensive benefits packages. And so one way is they try [00:26:30] to use, uh, essentially profit based compensation. So if the business is more profitable, then the, uh, the employee earns more money.
Jeremy Wells: Now, if that's done through payroll, then that's just another way of just calculating bonuses. That's increasing salary. It's also increasing payroll tax. Um, and so one way that uh, businesses, especially corporations, try to figure [00:27:00] out a way to get around that is through some sort of, uh, profits based interest in the corporation, so there's no actual equity being held. It's 0% ownership interest in the business, but there is some positive percentage interest in the profits of the business. So this is what's called a profits interest. Uh, I've also seen an arrangement [00:27:30] like this described as phantom equity, because, again, the employee doesn't actually own any part of the business, but they do have an interest in the profits of the business. Well, now, how do you get profits to, uh, an employee or shareholder or anyone? Well, you've got to distribute those profits, uh, to them. If it's not running through payroll, it must be some sort of distribution. And so we actually have [00:28:00] the opposite problem here, as we did before, Or where we have the operating agreement saying that some shareholders get more distributions than others. What we've got here with this profits interest is that we've got some shareholders getting distributions, but they have no rights to distributions in a liquidation because they [00:28:30] have no ownership interest in the business. And so that's why I've said that one class of stock rule is defined both in terms of distributions and liquidating distributions.
Jeremy Wells: And it's that individual's right to those distributions and liquidating distributions that matters. So you can have an employee that has a profits interest with no ownership interest getting distributions. But they have no right to liquidating distributions. And that creates a second class [00:29:00] of stock. So we can't do that either. It's another reason to work with our S corporation owners, and especially those with employees, and make sure we understand more than just their financials. For the purposes of preparing tax returns, we really need to understand their entire business model, including their compensation model. We need to understand what they're thinking in terms of how they're going to compensate their employees, as well as the other shareholders. We need [00:29:30] to help them understand the rules. One class of stock. No one has any more or less rights to distributions or liquidating distributions than anyone else. And that's really the key to avoiding problems with the S Corporation, especially these sort of inadvertent termination situations that can relatively easy easily arise. There is some, uh, relief available uh, [00:30:00] for s corporations that face an inadvertent termination. So if the election was terminated due to the corporation ceasing to be an S corporation, or due to having passive investment income exceeding that 25% of gross receipts for three consecutive tax years that I discussed back in the prior episode. Uh, and the corporation believes that the termination was inadvertent.
Jeremy Wells: Then it can request permission from the IRS [00:30:30] to continue to be treated as an S corporation. This comes from code section 1362 F, uh, and also the, uh the regulation here is 1.1624. And this is really where we get, uh, the rules about relief for inadvertent terminations. Now, if the IRS determines whether the s termination was inadvertent, uh, That's really [00:31:00] it. The IRS makes that determination there. It's not up to the shareholders. It's not up to their tax advisor. Uh, it's really up to the IRS as to whether that's termination was inadvertent. The corporation has the burden of proof that's under Treasury Regulation 1.1 624B. It's important to keep that in mind. If you're working with an S corporation that finds itself in this situation, it's really up to the corporation [00:31:30] to prove that the termination was inadvertent, not to prove that the termination shouldn't have happened, but to prove that it was inadvertent. So, for example, back to the, uh, discussion of, uh, profits interests in an S corporation, it would really be up to that corporation to prove that the shareholders were not aware of the rule that, uh, there was reasonable cause, right, for requesting [00:32:00] this relief, uh, that they have fixed the situation they had. They have eliminated the profits interest, uh, from their corporation that they understand that they can't do that. Right. That would be the starting point for proving to the IRS, uh, that the, uh, the termination was inadvertent and that they want to keep going as an S corporation.
Jeremy Wells: The corporation requests a private letter ruling, um, [00:32:30] or a PLR, providing an explanation of all the facts and circumstances and describing steps taken to remedy the situation. Uh, and that's in Treasury Regulation 1.1 1362 for C relief, for an inadvertent termination of an election and a waiver of the tax on excess passive investment income. Uh, if we're dealing with that kind of situation. Those are separate determinations under the [00:33:00] jurisdiction of different IRS offices. So again, this is this is rare in my practice. I honestly, I've never had to deal with this kind of situation because I don't work with s corporations that have a lot of passive investment income. Um, they might have, uh, a few dollars of interest a year because there's a savings account attached to the operating checking account for the corporation. But, you know, most of the s corporations that I work with, uh, they it's it's 99 plus percent [00:33:30] active income. It's very it's almost no passive income. And besides, like I said before, they have very little, if any history of being a C corporation. However, if you find yourself in a situation where you're dealing with an S corporation where the election has been inadvertently terminated due to excessive passive income, then that is a separate issue from [00:34:00] the request to waive the tax on that excess passive investment income. Those are two separate offices within the IRS. So the grant of the waiver on the tax does not waive, uh, the termination that may have taken place.
Jeremy Wells: That's from a chief counsel advice. So it's important to keep in mind if you're dealing with a situation like that, that those are actually two different determinations within the IRS. [00:34:30] Now, given the popularity of s corporations for small businesses and the ease with which an S corporation could inadvertently terminate its election, the IRS published uh Revenue Procedure 2220 2219. Now, in that rev proc the IRS is full blown. Admit we're getting way too many requests for plars [00:35:00] due to inadvertent selection terminations. That's that's in the preamble to that rev proc. Uh, the associate chief counsel for pastors and special industries, and I'm quoting here, frequently receives requests for plars seeking relief under section 1362 F to address a potential inadvertent invalid election or termination. So this rev proc is essentially a response to the rising [00:35:30] popularity of s corporations, and really what amounts to just a lack of acumen and expertise guiding the operation of these corporations. It seems like what's happening is there are a lot of s corporations out there, people running them that frankly don't know what they're doing. It's very easy for them to violate the rules. They a lot of times, uh, a shareholder will die and [00:36:00] that shareholders, uh, trust or estate becomes the shareholder, uh, takes the place of the deceased shareholder in that's corporation. And that trust or estate is not an eligible, uh, shareholder in the S Corporation.
Jeremy Wells: Now, there is some relief and there is a process for dealing with that. But a lot of s corporations don't know how to manage that. Or it might take too much time before the corporation's tax [00:36:30] advisor is brought in and they figure out how to handle the situation. And so in that time frame, they might not do the paperwork that's necessary to prevent the inadvertent termination. Or you might have a shareholder sell her interest to an Ineligible individual or entity not knowing the rules. And it's a while before the corporation's tax advisor finds out about it. So [00:37:00] in these situations, you just very easily have a lot of inadvertent selection terminations. And so what the IRS said is we need a process where instead of having to request a PLR, which is expensive and takes quite a bit of time for the IRS to process that request and then respond with the PLR instead of doing that. What this does is it provides six areas in which [00:37:30] an S corporation can seek relief without requesting a PLR. So these situations are breaking the one class of stock rule. This is a pretty consistent one as I discussed before. Disproportionate distributions. Now, again, the disproportionate distributions themselves are not problematic as long as they aren't driven, uh, by, uh, the [00:38:00] governing documents dictating that they have to happen. But the disproportionate or the non pro rata distributions are themselves indicative of an S corporation that is not playing by the rules.
Jeremy Wells: Uh another area is inadvertent errors on form 2553. And if we're talking about a qualified subsidiary then form 8869. So what might happen is there is an error on [00:38:30] form 2553. The election is made and processed and accepted. The error is discovered and then the election is terminated. Another way that this might happen is the corporation is acting as an S corporation. It files 2553 with an error, but it's rejected. And then, uh, the election uh, is in limbo, essentially. [00:39:00] And so anytime there is some sort of, uh, inadvertent error on the election form itself, form 2553, this rev proc is going to provide the corporation with a means of addressing it and seeking relief without requesting a PLR. For those who work with S corporations, you know that getting a copy of the acceptance letter for the selection is important. However, that [00:39:30] doesn't always happen. And in fact, in my experience, it very rarely happens. Uh, not that the the acceptance letter isn't sent, it's just getting that from the client can often be problematic, especially during the pandemic years when the IRS was really slow to get paperwork processed. Then what often [00:40:00] happened was we would send in elections and it would be six, 12, sometimes 18 months later before anything was heard about it. And so we might have filed at least one, if not two tax returns for that's corporation. 1120 S and we still haven't received any sort of confirmation that the election was received.
Jeremy Wells: Sometimes it turned out, uh, that the, uh, the corporation had actually received the acceptance letter. But by [00:40:30] the time we got around to asking for it, the, uh, the corporation and by corporation, I mean the shareholder, the client either misplaced it or got rid of it or forgot about it. And we never actually get that acceptance letter in our files. Obviously, that's not ideal. We definitely want a copy of that. There is a way to request a copy of that acceptance [00:41:00] letter, so I strongly recommend going through that process if you don't have one. Um, if you can. But again, that's going to get sent to the corporations address which means the client. So you're going to have to get a copy of that from the client. But that acceptance letter can come in handy, especially if you've got a challenge to whether that selection was in fact made or not. Given the state of the IRS lately, it's entirely possible that you get a notice for an 1120 [00:41:30] S that's been rejected because IRS can't find the election in their files when you know you correctly and timely sent in that election. So it's always a good idea to have that acceptance letter if you can get a hold of it. Another area is filing a return inconsistent with an election or, in the case of a qsub, a qualified subsidiary election such as form 1065 or form 1120.
Jeremy Wells: I've had [00:42:00] situations like this and I and I've had it go both ways. I've had situations where we filed an 1120 S and come to find out that a 2553 was never actually filed. The election was never actually filed. It should have actually been, uh, a 1065, uh, the entire time or even a schedule C. This relief is for a situation where the corporation filed the election. The [00:42:30] election was accepted, but the corporation continued. Uh, or the entity continued to file the wrong tax return type. So imagine a multi member LLC that elects the tax preparer doesn't know because it's entirely possible legal counsel or one of the members of the LLC or a different tax advisor actually files the election, and the individual [00:43:00] preparing the return is never told. In that case, the multi member LLC might still file a form 1065 and none of the shareholders, uh, really understand the difference. Uh, they're still getting k-1s, so they don't really notice that anything is wrong. Uh, and maybe it's a while. It's a year or two before anyone catches on and realizes, uh, this is the wrong return [00:43:30] type. Maybe it's an IRS notice that, uh, Spurs. That. And so if you've got an entity that's filing the wrong return type, but it's doing so in good faith, right. It's just inadvertently filing the wrong return type. Uh, then this red proc can provide relief for that.
Jeremy Wells: And then finally is the the final area here of the six listed in this red proc is non-identical governing [00:44:00] provisions. And this really gets back to uh, the one class of stock rule. So, so really you've got you've got three of these six that are all pretty closely related. Uh, the first one was breaking the one class of stock rule. The second was disproportionate distributions. And this last one, the sixth one is non-identical governing provisions. And this is just a way of saying that the governing documents or the operating agreement, uh, creates some sort of system that gives, [00:44:30] uh, Unequal right to distributions and liquidating distributions to different members of the LLC. And that's that's definitely not allowed. That's a violation of the one class of stock rule. So you can see how those three different areas all fit together. And in fact, those three would probably have identical results in terms of the operation of the corporation. Um, but, uh, [00:45:00] if the key here, uh, in this rev proc, the key for the corporation to keep in mind is that relief is available. If the corporation discovers the error and makes an effort to address it and actually fix it before the IRS, uh, notices. So, again, it's incredibly important that as the tax [00:45:30] advisor, or even just the tax preparer for an S corporation that you read through the governing documents of these S corporations or these LLCs intending to make an selection. Because if you notice in the language something that might violate the one class of stock rule, something that might require disproportionate distributions, something that gives nonidentical governing provisions to [00:46:00] different members within the LLC.
Jeremy Wells: If you notice that kind of language, it's going to be in your best interest and in your client's best interest to raise awareness of that fact among the LLCs members and get them to revise their operating agreement, hopefully with some good legal counsel, so that they can avoid any of these inadvertent termination Issues, but it's really important [00:46:30] that the corporation that the members of the LLC, uh, discover the issue first and that they fix it. And then if there is an inadvertent termination that they can show that they've already addressed it, um, or are aware of it and are, uh, and are addressing it are in the process of addressing it, it's going to be really important. It's going to be really helpful and beneficial to be able to show that and demonstrate that first, for the tax year of termination, [00:47:00] uh, for the portion of the year ending before the first effective date of the termination, the corporation is going to file a short year return for that corporation, and then for the remaining portion of the tax year beginning on the effective date of the termination. The corporation is going to file a short year return as a C corporation, says IRC section 1360 2E1. One. This is critical to understand. When an selection terminates, [00:47:30] the entity is then treated as a C corporation.
Jeremy Wells: It does not revert back to the default entity type if that uh, IT entity is an LLC. The default entity type of an LLC is either a sole proprietorship or a partnership if it's multi-member. But once the selection is made for that LLC. Now if [00:48:00] that selection terminates, that entity is then treated as a C corporation. There's an extra step that I'm going to talk about in a minute that has to be made. If you want to get that entity back to being its default type, the S Corporation is going to assign a pro rata share of all of its items of income, loss deduction and credit to each day of the year of termination. Basically, you're going to take the year, the annual PNL, and for however many days of the year [00:48:30] it was an s corporation up to the day of termination. That amount is going to go on the short year's corporation return. The remainder is going to go on the C Corporation return for the remainder of the year. Now, anyone who's a shareholder in the corporation at any time during the short year, and for the S Corporation and anyone who's a shareholder in the corporation on the first day of the C Corporation, [00:49:00] short year can elect to have items assigned to each short tax year on the basis of its normal tax accounting method. So what do we mean here? If you can identify those items of income expense loss credit.
Jeremy Wells: Uh, if you can identify when in the calendar, those actually happened, then those shareholders can elect to report them on their respective [00:49:30] returns based on when they happened in the year. So according to the corporation's books and records, if you can show that that income wasn't earned evenly throughout the year, but rather the bulk of it was earned earlier in the year or later in the year, then you can divide up those amounts on those returns that way. But that requires an election statement with the C corporation tax return, and then each shareholder has to provide written consent. [00:50:00] So there's a lot that goes into that election. It would be a lot easier to just do it pro rata. But if there's a significant difference in the amount of income based on when that income actually occurred through the year, it might behoove you and the shareholders to look into doing it that way. Now, the corporation can't use the pro rata approach. If ownership of the S Corporation changes by 50% or more of the issued and outstanding shares of stock of the corporation. [00:50:30] Rather, it assigns income, loss deduction and credit based on its normal method of accounting. So in that case, if the ownership changes significantly more than 50% than they're required to use, the normal method of accounting approach to allocating the income throughout across the two short year returns, and then the due date of the short year's corporation tax return is the same as the due date of the short year C Corporation return, [00:51:00] so both of them would be due unextended by the 15th day of the fourth month, or usually April 15th of the following year.
Jeremy Wells: What are some of the implications of terminating an S election? The main one is the five year rule. A corporation that terminates its s election can't elect S for five years after the year of termination without IRS consent. That section 1362 G. Now, the corporation can allow the corporation [00:51:30] to make a new election before the five year period expires. But the corporation has to establish, under relevant facts and circumstances that the Commissioner could consent to the new election. And there are some rules to that in Treasury Regulation 1.1 1362 five that are important to look at. However, in general, a corporation that terminates its selection can't make another selection [00:52:00] in the next five years. Now, the IRS will usually approve a new selection before the waiting period expires. If 100% of the stock in the corporation is owned by a shareholder who did not own any stock when the s election was terminated. So in other words, in general, if there has been a complete change in ownership of the corporation, then the IRS will typically [00:52:30] allow a new selection inside of that five year period. And that's coming from revenue ruling 78 332. That might be important.
Jeremy Wells: If you've got an entity that terminates its selection, it changes its ownership 100%, and then the new ownership wants to make an selection. You might be able to avail yourself of this revenue. Ruling 78 332 in order to make that happen, the five year rule doesn't apply [00:53:00] when an S corporation revokes its election effective on the first day of the tax year for which its election was to be effective, or fails to meet the definition of an S corporation on the first day of the first tax year for which its election was to be effective. So again, think about this, right. If it's a prospective election, meaning we're going to elect for this s corporation for this, for this company to be an S corporation as of the beginning [00:53:30] of next year. And between now and then, right in the remainder of this year, we either are no longer eligible to be an S corporation or we decide we don't want to be an S corporation, then we're terminating that prospective election. But we're not doing it in such a way that makes it to where we cannot elect S again within the next five years. That doesn't count. The five year rule doesn't count [00:54:00] if we revoke that prospective or can't fulfill that prospective election because the entity is no longer eligible. And again, revoking the s election for an LLC reverts the entity to a C Corporation. Filing that form 2553 is actually a 2 in 1 step process.
Jeremy Wells: First step was to make that entity an association, which is treated as a [00:54:30] C corporation under Treasury Regulation 301.77013. Then the next step is to have that association treated as an S corporation. So when the S Corporation revokes its election it is now a C corporation. It does not go all the way back to the default entity type in order for that to happen. It would then need to file form 8832 if [00:55:00] it's eligible to do so, in order to elect back to default classification. Now, the only way it can do that At is if it's eligible to make that election back to its default status, that requires that it made the original election on the registration date of the entity, or that it's been at least 60 months, five years [00:55:30] since the effective date of that election. So otherwise the entity is going to need a peeler. Um, if more than 50% of the ownership, uh, is owned by persons with no ownership interest in the entity on the prior elections, effective date or filing date, that's one of the, uh, exceptions. The other exception is to that 60 month limitation is that it doesn't apply to a newly formed eligible entity that makes [00:56:00] an entity classification election effective on its formation date, which is what I just said. So those are the two exceptions. So if you have an LLC registered one day. It makes a selection on a later day.
Jeremy Wells: It then it revokes that election. Then it has to wait 60 months or five years before it can elect back to that LCS default state. Otherwise it's a C corporation. In the meantime, unless it meets one of those two exceptions. So [00:56:30] that is the gist of how you can end an S corporation. So again, if you haven't listened to part one, I strongly recommend going back and listening to that. That was an overview of the three ways that an election can terminate either revocation, or another way of doing that is withdrawal. By not being eligible as a small business corporation or due to excessive passive investment income. And then there is some relief [00:57:00] for an inadvertent termination. It's especially important to go through that rev proc uh that Riprock was 20, 2219. In order to look at those six different types of inadvertent termination, uh, causing events or causing qualities of the entity to see if those can help a client of yours, if they're facing an inadvertent selection or a potential inadvertent election. [00:57:30] And then we have to remember that getting that entity back to being an S corporation is going to come with some limitations. Um, and there are some exceptions, but in general, it's going to be pretty difficult for that entity that terminates its selection to then reelect s within the next five years. So that's part two of this series on ending an S corporation. I hope you found this valuable. Thank you.