Business owners looking to exit their business need to appropriately plan for their exit. Since approximately half of business owners’ exits are unplanned, it is important to ensure corporation stock documents are in order. Incorrect documentation or failed elections can result in the business owner paying more in federal income taxes.
In any transaction there are potential tax issues to consider. When acquiring the stock of an S corporation (a special type of corporation created through an IRS tax election that can avoid double taxation for its shareholders), the most critical question is the validity of the S election. With a valid S election, the target is generally not subject to federal income tax at the corporate level, rather the individual shareholders are subject to tax on their distributive share.
A new corporation eligible to make an S election must file Form 2553 on or before the 15th day of the third month following the “activation date” of the corporation. This is usually the earliest of the date the corporation has shareholders, acquires assets or begins doing business.
Existing corporations that wish to elect S status can do so by filing Form 2553 during the year preceding the first year the S election is to be effective or, on or before the 15th day of the third month of the initial S year.
While these requirements may seem simple, elections are often missed, shareholder signatures are missing or the entity may have inadvertently terminated the election after it was properly made. So what are the methods to repair invalid elections? The IRS offers various ways to repair missed or invalid elections.
If a company discovers it has not filed an election by the required due date, the IRS offers relief for late elections. Under Revenue Procedure (Rev. Proc.) 2013-30, an entity may file for relief if it meets the specific requirements below:
- The entity intended to be classified as an S corporation as of the effective date;
- The entity requests relief within 3 years and 75 days after the effective date;
- The failure to qualify as of the election date was solely because the election was not timely filed; and
- The entity has reasonable cause.
Failure to obtain shareholder consents
If an entity discovers it inadvertently failed to obtain the consent of one or more shareholders, it may file for late relief pursuant to Section 1.1362-6(b)(3)(iii) of the income tax regulations (Reg. Sec.). There is no specific due date for filing for relief, but the entity should file as soon as it discovers it has failed to obtain a shareholder consent. The entity will qualify for relief if:
- There was reasonable cause for failure to file the consent;
- The request for the extension of time to file a consent is made within a reasonable time under the circumstances; and
- The interests of the Government will not be jeopardized by treating the election as valid.
Failure to obtain spousal consents in community property states
Various states are community property states, in which a married shareholder residing in these states must obtain the consent of his or her spouse. Automatic relief is provided in Rev. Proc. 2004-35. Automatic relief is available if all of the following conditions are met:
- The S corporation election is invalid solely because the Form 2553 failed to include the signature of a community property spouse who was a shareholder solely pursuant to state community property law; and
- Both spouses have reported all items of income, gain, deduction or credit consistent with the S corporation election on all affected federal tax returns.
A corporation may inadvertently terminate its S election if it transfers stock in a form of joint ownership resulting in more than 100 shareholders, or stock is pledged as collateral for a loan and, upon default, the stock is acquired by an invalid shareholder. A waiver can be requested from the IRS under Reg. Sec. 1.1362-4(c). The request can be made if:
- A previous valid S election was made;
- The entity establishes that a disqualifying event was inadvertent;
- The entity corrects the situation with a reasonable period of time; and
- Agrees to any adjustments required by the IRS pertaining to the period the corporation was in violation of the S eligibility rules.
When an S corporation is the target in an acquisition, the validity of the S election is one of the most critical federal tax items. However, the IRS offers various methods of late relief that can help repair late or invalid S elections. When analyzing whether your business is ready for sale, this is one of many issues a business owner should consider, and documentation they should be obtaining. Analyzing the business in advance to determine if it is ready to transition is the key to a successful transaction.