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Closely held corporations typically elect to be treated as S Corporations because doing so allows their shareholders to continue to have the legal benefits of operating in corporate form, and also allows them to enjoy a single level of tax, pass-through deductions, and the availability of certain entity losses to offset other income. However, not all corporations may elect S status. The election is only available to qualifying “small business corporations,”[1] meaning that: (1) the corporation has no more than 100 shareholders;[2] (2) all of the corporation’s shareholders are individuals, estates, certain eligible trusts, or certain exempt organizations;[3] (3) none of the corporation’s shareholders is a nonresident alien; (4) the corporation has only one class of stock issued and outstanding;[4] (5) the corporation is a U.S. corporation; and, (6) the corporation is generally not a financial institution, insurance company, or a DISC.[5] A corporation elects to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (“IRS”).[6] A valid election is effective for the corporation’s taxable year for which it is made and for all succeeding taxable years, until the election is terminated.[7]
An election may be terminated in several ways; however, one of the more common termination events occurs when a corporation ceases to be a small-business corporation (i.e., it no longer meets the eligibility requirements referenced above). Small business corporations, for example, may only have certain types of shareholders – no corporations, partnerships, nonresident alien individuals, and many types of trusts.[8] When a shareholder inadvertently transfers his or her interest to an ineligible shareholder or dies and his or her interest is transferred to a trust that is either not eligible to be a shareholder or has not made the proper election to be recognized as a Subchapter S trust (“QSST”) or an electing small business trust (“ESBT”),[9] the corporation’s election will effectively terminate.
If a corporation fails to immediately address an inadvertent termination after discovery, the IRS may reat the taxpayer as if the election was never made, subjecting it to the corporate level taxes that apply to C corporations and possible other collateral tax consequences. The good news is that the IRS may be willing to grant relief by waiving the accidental termination and, assuming certain requirements are met, continue to treat the corporation as an S corporation. The IRS also has the authority to waive the effect of an invalid election caused by an inadvertent failure to qualify as an S corporation or to obtain the required shareholder consents (including elections regarding qualified subchapter S trusts or electing small business trusts), or both.[10]
Rev. Proc. 2013-30, amplified by Rev. Proc. 2022-19,[11] provides the exclusive methods for taxpayers to request relief for late elections. Submitted requests must meet certain timing restrictions and must describe the reasonable cause for failure to file a timely election, or that the failure to file the election was inadvertent, and the diligent actions taken to correct the mistake upon its discovery. In instances where Rev. Proc. Relief is unavailable, an inadvertent termination waiver may also be requested by submitting a private letter ruling (“PLR”) request to the National Office of the IRS in Washington, D.C.[12] Requesting a private letter ruling can be an expensive endeavor, however, and requires careful preparation and adherence to certain IRS procedural guidelines.
Because of the strict rules governing the election and maintenance of S corporation status, S corporations and their shareholders should consult with their tax attorneys and accountants whenever a question as to shareholder eligibility or a transfer of shares arises.
Michelle E. Espey is a Partner at Farrell Fritz, P.C. Michelle counsels clients on a broad range of tax matters, from representing individuals and corporations at all stages of Federal, State and New York City tax disputes to advising clients on the tax aspects of various transactions. Michelle currently serves as Co-Chair of the Suffolk Bar’s Taxation Law Committee and can be reached at mespey@farrellfritz.com.
Published in the Special Section: Tax Law of the April 2025 edition of The Suffolk Lawyer
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[1] See §1361(b)(1) of the Internal Revenue Code (“I.R.C.”) of 1986, as amended. Note that there are no restrictions on the size of the corporation in terms of assets or revenues.
[2] I.R.C. §1361(b)(1)(A)
[3] I.R.C. §1361(b)(1)(B)
[4] Differences in voting rights are permitted
[5] I.R.C. §1361(b)(2)
[6] To be valid for a particular year, an S election must be filed by the 15th day of the third month of the taxable year or at any time during the corporation’s preceding taxable year.
[7] I.R.C. §1362
[8] See IRC §1361(b)(1)(B) and (C). Another common error that S corporations make—making a disproportionate distribution—potentially can be viewed as creating a second class of stock and terminating S corporation status.
[9] Rev. Proc. 2013–30 provides a concise process for seeking relief for late elections on behalf of trusts that own S corporation stock.
[10] I.R.C. §1362(f).
[11] Rev. Proc. 2022-19 provides taxpayer assistance procedures to resolve these frequently encountered issues without the need to request a Private Letter Ruling.
[12] See Reg. §1.1362-4(c). Ruling request procedures are updated annually by the IRS, generally in the first revenue procedure of the calendar year.