For certain eligible businesses, electing to be taxed as an S corporation is a smart choice. As soon as an S corporation fails to meet certain requirements to maintain its status, however, the S corporation election will automatically terminate. For example, an S corporation election will be terminated if the corporation is sold to a shareholder that is not an eligible S corporation shareholder (e.g., a partnership).
Fortunately for those who wish to avoid this result, the Commissioner of Internal Revenue (the “Commissioner”) can ignore the termination of an S corporation election if the Commissioner determines that the circumstances resulting in the termination were inadvertent and if corrective action is undertaken to come into compliance with the requirements within a reasonable period of time after the discovery of the circumstances resulting in the termination. In these instances, the burden is on the corporation to establish that the Commissioner should make this determination. To do this, the corporation may submit a ruling request to the Internal Revenue Service (the “IRS”) providing an explanation of the circumstances causing the termination, how the circumstance was discovered, and the remedial steps taken.
The status of the corporation after the terminating event is determined by the Commissioner. Inadvertent termination relief may be granted retroactively (in which case, the corporation is treated as if its election were valid and had never terminated). Relief may also be granted only for the period in which the corporation brought itself back into compliance and became eligible again for S corporation status. In addition, the Commissioner may require any adjustments that are appropriate. For example, it may require an ineligible shareholder to be treated as a shareholder of the S corporation during the period the ineligible shareholder actually held stock in the corporation.
In Private Letter Ruling 201902013, for example, an S corporation election was terminated when all of the corporation’s shares were transferred to a partnership, which is an ineligible shareholder. When the corporation learned that the transfer terminated its S corporation election, the corporation and its shareholders took remedial action by having the partnership transfer all of its shares in the corporation to eligible S corporation shareholders. The IRS ruled that the corporation would continue to be treated as an S corporation on and after the date on which the election had terminated (provided that the corporation’s S corporation election was otherwise valid and not otherwise terminated), and that the partnership would be treated as the shareholder of the corporation from the date of the transfer of the shares to the partnership until the transfer of the shares to the eligible S corporation shareholders.
If you are a shareholder in an S corporation and are concerned that it no longer meets the requirements to be an S corporation, an experienced tax attorney can assist with making this evaluation, and, if necessary, taking corrective steps and submitting a ruling request to the IRS.