Now that the most pressing deadlines for filing 2003 tax returns are behind us, it’s time to switch gears and return to a more planning-driven mindset.
One growing frustration, however, is the amount of tax planning that is being forced upon us during filing season by way of an increasing number of elections and other choices tied directly to current filing dates.
More frustrating still is the fact that many of these elections impact returns that won’t be prepared until a year from now, rather than affecting returns prepared this season. The S corporation election represents a prime example of this compression of planning and compliance.
In the typical rush of tax season, some election deadlines understandably may be missed. After all, the Internal Revenue Code contains scores of elections. The good news is that many deadlines can be extended. In fact, “deadlines” for an election are somewhat elusive, since automatic extensions or extensions with Internal Revenue Service permission are liberally available. A review of these extensions, especially in connection with new relief available to save late S corporation elections, may be especially helpful while these extended periods still remain open.
Types of extensions
Extensions tacked onto regular election deadlines come in several shapes and flavors:
- Automatic six-month extension. For most elections keyed to the due date of the return, an automatic extension of six months from the due date of the return excluding extensions is granted to taxpayers who have timely filed the return for the year that the election should have been made. Any filing made to obtain an automatic extension must state at the top, “FILED PURSUANT TO §301.9100-2.”
- Automatic 12-month extension. A handful of specific elections granted by regulations are eligible for automatic 12-month extensions running from the original due date of the election. Elections eligible for the automatic 12-month extension include the election to use a tax year other than the required tax year; the election to use the LIFO method; the 15-month rule for filing exemption applications for specified exempt organizations; the 15-month rule for filing an exemption application for a charitable religious, educational, etc. organization; the election to adjust basis on partnership transfers and distributions; the election to be treated as a homeowners association; the gift tax election to ignore a qualified payment right; the gift tax election to treat any distribution right as a qualified payment; and the estate tax election to specially value qualified real property.
- Discretionary extensions. If an election does not qualify for one of the automatic extensions, the taxpayer may still receive an extension if the taxpayer acted reasonably and in good faith, and granting the election does not prejudice the interests of the government. A taxpayer who requests an extension before the IRS discovers the failure to make the election is deemed to have acted in good faith if the failure is due to intervening events beyond the taxpayer’s control; if the taxpayer was unaware of the necessity for the election after exercising reasonable diligence; or if the taxpayer reasonably relied on the written advice of the IRS or on a qualified tax professional who failed to make or inform the taxpayer of the election.
Special S election relief
Despite a growing trend for small businesses to operate as partnerships, the S corporation holds distinct advantages. Although a partnership often offers more flexibility in manipulating the tax laws than an S corporation, the S shareholders’ limited legal liability and flow-through treatment of income and losses often win the comparison test.In this regard, making certain that an S corporation election is valid is crucial. An invalid election can mean delaying S corporation status for a year and facing the headaches and expense of conversions from C corporation or partnership status to S corporation status in the following year. For the start-up business, this could mean the difference between success and failure.
Due to some relatively recent relief provisions, however, a late or otherwise invalid election no longer necessarily means no election. Special procedures apply to untimely Subchapter S elections.
S election extensions
For an S election to apply to the current tax year, the corporation must have filed a valid election during the preceding tax year or within two months and 15 days of the current tax year. If the election is not made and postmarked until after the 15th day of the third month of the tax year, the election takes effect for the following year, unless a special relief provision applies. Relief comes in regular letter ruling and streamlined sizes.
The IRS noted that Congress intended that the agency exercise its discretionary power reasonably. At the same time, Congress did not want waivers to be made so freely that taxpayers would deliberately fail to make timely S corp elections to avoid or lower their tax liabilities. Relief cannot prejudice the government.
Streamlined S relief
Taxpayers can take advantage of streamlined procedures under Revenue Procedure 2003-43 for requesting relief for late S corporation elections. (The procedure also may be used for late-electing small business trust elections, qualified Subchapter S trust elections and qualified Subchapter S subsidiary elections.)
The new procedure is to be followed in lieu of the letter ruling process that is ordinarily used to obtain relief for a late election under Subchapter S. Use of the new, streamlined procedure avoids the user fee that is required for a letter ruling, in addition to the delays and uncertainties inherent in that process.
The old approach. Prior to Rev. Proc. 2003-43, a corporation was eligible for special streamlined relief if three requirements were met:
1. The corporation failed to qualify as an S corp on the first day of the year in which S corporation status was first desired solely because it did not timely file Form 2553, Election by a Small Business Corporation.
2. The corporation had reasonable cause for failing to timely make the S election (misunderstanding or inadvertence).
3. The due date for the tax return excluding extensions (i.e., March 15 for calendar year taxpayers) for the first year the corporation intended to be an S corporation had not passed.
If a corporation met these criteria, it had to file Form 2553 within 12 months of the original S election deadline or, if earlier, the due date for the tax return, excluding extensions, for the first year that the corporation intended to be an S corp. (Note that this rule remains in the current Instructions for Form 2553, which were last revised in December 2002, prior to the new streamlined procedure.)
The new approach. Rev. Proc. 2003-43 keeps requirements No. 1 and No. 2. Requirement No. 3, however, has been liberalized significantly by extending the time within which special relief must be requested to the longer of two alternative deadlines.
Which alternative applies depends upon whether or not the corporation has already filed a return for its first year as an S corporation (under the mistaken belief that a good S election had been made).
The alternative deadlines for revised requirement No. 3 are:
- Within six months after the due date for the tax return including extensions for the first year the corporation intended to be an S corporation (i.e., Sept. 15 for calendar year taxpayers), provided all S shareholders have not yet reported their share of any of the corporation’s income in a way inconsistent with an S election for the intended first year; or,
- Within 24 months of the original deadline for making the election, provided that an actual S return has been filed within six months of the original due date without extensions (Sept. 15 for calendar year taxpayers) under the mistaken belief that the S election had been valid, and that S shareholders have reported their share of the corporation’s income consistent with that return.
The old rule required the election to be filed by March 15 of the year for the calendar year to which the election applied. The new extension procedure now extends that deadline by either six months or 12 months.Defects extensions can’t cure
Even if the election is filed within the first two months and 15 days of the tax year for which the election is to be effective, the election is not effective for that year unless the corporation qualifies as a small business corporation for the entire period from the beginning of the year until the election is made. If the corporation does not qualify during that period, the election is effective for the following year.
An election filed before the corporation is in existence for federal tax purposes is invalid. If the corporation does not qualify as a small business corporation when the S election is filed, however, the election will be valid as long as the corporation has satisfied the requirements before the first day of the tax year for which the election is effective.
This small business requirement for an election should not be confused with relief from an ineffective initial election through the letter ruling process (although the rules are similar). Automatic relief for late S corporation elections in this situation is available when:
- The corporation intends to be an S corporation.
- The entity and its shareholders report their income in a manner consistent with S status for the tax year in which the election should have been made and for every subsequent tax year.
- The entity has not been notified by the IRS of problems regarding its status within six months of timely filing its first Form 1120S, U.S. Income Tax Return for S Corporations; and,
- The six months referred to in the item above have passed.
Short period planning
Rather than put a taxpayer at the mercy of the IRS in deciding whether one of the extensions is warranted, tax-year planning may prove to be a more certain route if the missed deadline is recent.If a new corporation’s first tax year is a short period of less than two and one-half months, an S corporation election for the short period must be filed within two months and 15 days after the first day of that short tax year. For a calendar year corporation starting on Jan. 1, this election deadline is March 15. The first month of a corporation’s initial tax year begins when the corporation has shareholders, acquires assets or begins doing business, whichever takes place first.
For an initial tax year starting May 1 and ending on Dec. 31, for example, the S election deadline for the first year is July 15. In this situation, some planning may take place if the end of July arrives and someone suddenly realizes that an election has not been made.
Rather than then suffer possible C corporation treatment for the May 1 through Dec. 31 period, the corporation could elect a first tax year ending, for example, on June 30. That first year would be taxed under C corporation rules (which, being a start-up, should not yield the corporation a significant built-in gains problem).
Doing so, however, allows the initial S election for the next year to be made by Sept. 15, avoiding any question of entitlement to S corporation status starting July 1.
George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.
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