United States

Being careless with dates can compromise a company's sub S status

An ESBT election with wrong effective date terminated company’s status

TAX ALERT  | 

The IRS recently granted relief (PLR 201941003) to an S corporation whose status terminated due to carelessness – a shareholder indicated the wrong date on an election form. The ruling serves as a good reminder that S corporations and their shareholders should be wary of common 'foot faults', such as imprecision when completing election forms. Even a minor mistake can result in the loss of the company’s subchapter S status. The IRS will typically grant relief, but they will charge a hefty user fee – currently $30,000 – to do so.

Background

In order to qualify as an S corporation, a company can only have certain types of shareholders. Among those potentially qualifying shareholders are certain types of trusts. However, in many cases a trust must make an election - either a qualified subchapter S trust (QSST) election or an electing small business trust (ESBT) election – to qualify as an S corporation shareholder. The trust at issue in the PLR did make an ESBT election, but it appears that it was careless when doing so.

Transaction

The ruling involved an S corporation that had an ESBT as a shareholder. As part of a plan, the ESBT merged with another trust, with the second trust surviving. This resulted in a transfer of the S corporation shares to the surviving trust on the date of the merger. The surviving trust recognized the need to file a new ESBT election, but when doing so indicated an effective date subsequent to that of the merger. Although the magnitude of the difference between the merger date and the ESBT effective date is not clear from the ruling, it is important to recognize that any difference would terminate the company’s subchapter S status. 

Because of the failure to indicate the correct effective date, the S corporation temporarily had an ineligible shareholder, which terminated the company’s status on the day of the merger. 

Conclusion and Takeaway

The IRS granted relief and agreed to continue to treat the company as an S corporation. However, the cost of that relief is significant – the IRS user fee to request relief for inadvertent S corporation terminations is currently $30,000, excluding professional fees.   

While these types of mistakes might be viewed as mere foot faults, they can nevertheless result in major issues, and major expenses. There is no margin for error with election dates – if a trust makes an error such as this, the company’s S election will terminate. To help avoid issues such as this, S corporations should take steps to be sure they have visibility into the activities of their shareholders, particularly trust shareholders. If an error such as this is discovered early enough, there are certain steps the parties can take to potentially get automatic relief and avoid the ruling request process. However, if the issue is discovered years later, the only remedy will be the letter ruling process.

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