Mistaken S Corp Election???

[jbauer1626]

I have a client who is a fiscal year end C Corporation however a S election was made in 2005. We, the accounting firm, have no record of this and have continued to file the Corporation as a fiscal year end C Corp. The IRS now is requesting that we refile the returns for our client as a S Corp with a calendar year end and of course this is causing a substantial tax liability. Is there anything that can be done? Any help would be most appreciated.

Thanks,

 

[tranquility]

What facts indicate the election is "mistaken"?

Nothing can be done without knowing the facts of the "mistake".

If there is no legal mistake where you can argue there was some scrivener's error, the real answer lies in Sec. 1362.

If not a mistake, regarding S-corp elections:

(d) Termination
(1) By revocation
(A) In general
An election under subsection (a) may be terminated by
revocation.
(B) More than one-half of shares must consent to revocation
An election may be revoked only if shareholders holding more
than one-half of the shares of stock of the corporation on the
day on which the revocation is made consent to the revocation.
(C) When effective
Except as provided in subparagraph (D) -
(i) a revocation made during the taxable year and on or
before the 15th day of the 3d month thereof shall be
effective on the 1st day of such taxable year, and
(ii) a revocation made during the taxable year but after
such 15th day shall be effective on the 1st day of the
following taxable year.
(D) Revocation may specify prospective date
If the revocation specifies a date for revocation which is on
or after the day on which the revocation is made, the
revocation shall be effective on and after the date so
specified.
(2) By corporation ceasing to be small business corporation
(A) In general
An election under subsection (a) shall be terminated whenever
(at any time on or after the 1st day of the 1st taxable year
for which the corporation is an S corporation) such corporation
ceases to be a small business corporation.
(B) When effective
Any termination under this paragraph shall be effective on
and after the date of cessation.
(3) Where passive investment income exceeds 25 percent of gross
receipts for 3 consecutive taxable years and corporation has
accumulated earnings and profits
(A) Termination
(i) In general
An election under subsection (a) shall be terminated
whenever the corporation -
(I) has accumulated earnings and profits at the close of
each of 3 consecutive taxable years, and
(II) has gross receipts for each of such taxable years
more than 25 percent of which are passive investment
income.
(ii) When effective
Any termination under this paragraph shall be effective on
and after the first day of the first taxable year beginning
after the third consecutive taxable year referred to in
clause (i).
(iii) Years taken into account
A prior taxable year shall not be taken into account under
clause (i) unless -
(I) such taxable year began after December 31, 1981, and
(II) the corporation was an S corporation for such
taxable year.

The date termination is dealt with:

(e) Treatment of S termination year
(1) In general
In the case of an S termination year, for purposes of this
title -
(A) S short year
The portion of such year ending before the 1st day for which
the termination is effective shall be treated as a short
taxable year for which the corporation is an S corporation.
(B) C short year
The portion of such year beginning on such 1st day shall be
treated as a short taxable year for which the corporation is a
C corporation.
(2) Pro rata allocation
Except as provided in paragraph (3) and subparagraphs (C) and
(D) of paragraph (6), the determination of which items are to be
taken into account for each of the short taxable years referred
to in paragraph (1) shall be made -
(A) first by determining for the S termination year -
(i) the amount of each of the items of income, loss,
deduction, or credit described in section 1366(a)(1)(A), and
(ii) the amount of the nonseparately computed income or
loss, and
(B) then by assigning an equal portion of each amount
determined under subparagraph (A) to each day of the S
termination year.
(3) Election to have items assigned to each short taxable year
under normal tax accounting rules
(A) In general
A corporation may elect to have paragraph (2) not apply.
(B) Shareholders must consent to election
An election under this subsection shall be valid only if all
persons who are shareholders in the corporation at any time
during the S short year and all persons who are shareholders in
the corporation on the first day of the C short year consent to
such election.
(4) S termination year
For purposes of this subsection, the term ''S termination
year'' means any taxable year of a corporation (determined
without regard to this subsection) in which a termination of an
election made under subsection (a) takes effect (other than on
the 1st day thereof).
(5) Tax for C short year determined on annualized basis
(A) In general
The taxable income for the short year described in
subparagraph (B) of paragraph (1) shall be placed on an annual
basis by multiplying the taxable income for such short year by
the number of days in the S termination year and by dividing
the result by the number of days in the short year. The tax
shall be the same part of the tax computed on the annual basis
as the number of days in such short year is of the number of
days in the S termination year.
(B) Section 443(d)(2) to apply
Subsection (d) of section 443 shall apply to the short
taxable year described in subparagraph (B) of paragraph (1).
(6) Other special rules
For purposes of this title -
(A) Short years treated as 1 year for carryover purposes
The short taxable year described in subparagraph (A) of
paragraph (1) shall not be taken into account for purposes of
determining the number of taxable years to which any item may
be carried back or carried forward by the corporation.
(B) Due date for S year
The due date for filing the return for the short taxable year
described in subparagraph (A) of paragraph (1) shall be the
same as the due date for filing the return for the short
taxable year described in subparagraph (B) of paragraph (1)
(including extensions thereof).
(C) Paragraph (2) not to apply to items resulting from section
338
Paragraph (2) shall not apply with respect to any item
resulting from the application of section 338.
(D) Pro rata allocation for S termination year not to apply if
50-percent change in ownership
Paragraph (2) shall not apply to an S termination year if
there is a sale or exchange of 50 percent or more of the stock
in such corporation during such year.

If there was a true mistake:

(f) Inadvertent invalid elections or terminations
If -
(1) an election under subsection (a), section 1361(b)(3)(B)
(ii), or section 1361(c)(1)(A) (ii)by any corporation -
(A) was not effective for the taxable year for which made
(determined without regard to subsection (b)(2)) by reason of a
failure to meet the requirements of section 1361(b) or
obtain shareholder consents, or
(B) was terminated under paragraph (2) or (3) of subsection
(d), section 1361(b)(3)(C),or section 1361(c)(1)(D)(iii),
(2) the Secretary determines that the circumstances resulting
in such ineffectiveness or termination were inadvertent,
(3) no later than a reasonable period of time after discovery
of the circumstances resulting in such ineffectiveness or
termination, steps were taken -
(A) so that the corporation for which the election
was made or the termination occurred is a small business
corporation or a qualified subchapter S subsidiary, as
the case may be, or
(B) to acquire the required shareholder consents, and
(4) the corporation for which the election was made or the
termination occurred, and each person who was a shareholder in
such corporation at any time during the period specified
pursuant to this subsection, agrees to make such adjustments
(consistent with the treatment of such corporation as an S
corporation or a qualified subchapter S subsidiary, as the case
may be) as may be required by the Secretary with respect to
such period,
then, notwithstanding the circumstances resulting in such
ineffectiveness or termination, such corporation shall be
treated as an S Corporation or a qualified subchapter S subsidary,
as the case may be during the period specified by the
Secretary.

 

[davew128]

I have a client who is a fiscal year end C Corporation however a S election was made in 2005. We, the accounting firm, have no record of this and have continued to file the Corporation as a fiscal year end C Corp. The IRS now is requesting that we refile the returns for our client as a S Corp with a calendar year end and of course this is causing a substantial tax liability. Is there anything that can be done? Any help would be most appreciated.

Thanks,

So what happened when you asked your client if they ever made an S election?

 

[tranquility]

Uh-huh. What will the client say?

1. I didn't.

2. 5 years ago.

In the case of #2, there was no error and the OP must go through sections (d) and (e). In the case of #1, a letter is sent to the IRS saying "Huh?"

They reply:
1. Date and time of election.

2. My bad.

In the case of #1, the OP must go through sections (d) and (e) or try to prove in court they didn't do something. In #2, please send me the letter as, while the IRS is often wrong, they never admit it.

In reality, the question will be asked and the client will probably say something along the lines of "I remember talking about it, but don't remember anyone doing anything about it." When asked why they were signing corporate returns rather than S-corp ones, the reply will be "I don't know anything about that. You give me the paper with the flag to sign and I sign."

Asking the client is one part of the process to resolve the problem. However, it is unlikely the answer is going to change from the fact the IRS is looking for some S-corp returns. Woebetide the OP if the difference results in taxes owed. (States often care too.)

 

[davew128]

A 2553 was filled and SIGNED, and nobody (preparer, taxpayer, and IRS) has a copy of it?

Sorry, not buying it. I would be more inclined to believe a 2553 WAS filed and the IRS doesn't acknowledge it than I would be to believe it wasn't and the IRS says it was. I see problems all the time with people thinking they DO have an s-corp when they don't and have never seen an instance like this.

I am willing to bet the taxpayer either has a copy of the s election or the s status acknowledgment from the IRS.

 

[tranquility]

I am uncertain as to your response.

I agree the usual problem is a blown election where we want to be an S-corp and did not elect in a proper or timely manner. We agree that is not the problem here.

I agree it is highly likely an election was filed and an approval received.

But, what now?

EITHER there was an election or there was not.

In our facts,

I have a client who is a fiscal year end C Corporation however a S election was made in 2005.

I'm thinking there was an election.

The OP will need to file back at least the returns within the SOL. If the amounts are not gross misstatements, 3 years. Longer if large amounts. I believe the service can also claim returns have not been filed. There are varying court cases on if the SOL runs on the filing of a return even if the form is wrong. From a Chief Council Memorandum on a person filing a 1040 rather than the 1040NR which was required:

Generally, the Service has the authority to require taxpayers to file their returns on the
correct form; however, a document may qualify as a return so long as it meets certain
requirements. See Commissioner v. Lane-Wells, 321 U.S. 219 (1944); Germantown
Co. v. Commissioner, 309 U.S. 304 (1940); Zellerbach Paper Co. v. Helvering, 293 U.S.
172 (1934). In Beard v. Commissioner, 82 T.C. 766, 777 (1984), aff'd, 793 F.2d 139
(6th Cir. 1986), the court summarized the relevant Supreme Court case law as follows:
First, there must be sufficient data to calculate tax liability; second, the document
must purport to be a return; third, there must be an honest and reasonable
attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must
execute the return under penalties of perjury.

Since the corporate return does not supply sufficient data to calculate tax liability NOR would it be a reasonable attempt to satisfy the requirements of the tax law if the taxpayer knew he was an S-corp, I think the service can go back as far as to the election for returns.

 

[jbauer1626]

The IRS does have record of the S election. The client says it was sent to them on the advice of someone at our office however that person does not work here anymore. The client surely had no idea what they were signing. I have had many issues with the IRS stating they did not receive the 2553 but never this way. The reason I say mistaken is I do not believe the client intended for the Corporation to be an S Corp. They did file a 2553 but I do not beleive they knew what they were sending in.

 

[jbauer1626]

Also had we know about the election obviously we would have changed the way we handled this back in 2005. The IRS may have sent back an acknowledgement but our office never received it. The client may have but they never forwarded it on to us.

 

[tranquility]

The reason I say mistaken is I do not believe the client intended for the Corporation to be an S Corp. They did file a 2553 but I do not beleive they knew what they were sending in.

So, my understanding of your legal argument is that with the signing and sending in an official document to the government to affirmatively elect a legal tax position the taxpayer should be excused because he didn't understand what he was doing?

I think the election was made. If your office sent the election form to the client without proper explanation for understanding you might be at risk for malpractice. The reason for elections is to take different paths depending on the claim of how you want to legally decide some issues BEFORE the facts are in. To say the taxpayer didn't understand what the election meant AFTER the IRS comes looking for a return where the preparer feels additional tax is owed, even if true, is...convenient.

Also had we know about the election obviously we would have changed the way we handled this back in 2005. The IRS may have sent back an acknowledgement but our office never received it. The client may have but they never forwarded it on to us.

I suggest you review the file and see if you can contact the former employee who caused this mess. While I don't think the misfiling is malpractice, I could certainly make a case you should have known if the form was sent.

 

[jbauer1626]

There are a few variables here also...employee who sent it to them is no longer with the firm....partner who was here and may have advised them to do so is no longer with the firm. Nothing in the file shows that we advised them to become an S Corp but that doesn't mean there was not verbal communication. I am not trying to exonerate anyone here I am just wondering if there is anything out there that would help them get relief from the situation. I am the new sole owner of the firm and would like to help them out anyway I can. I would assume I am still liable for this since I bought the firm and in doing so assumed past liabilities. So I guess I am trying to get myself out of the fire also.

 

[tranquility]

I am not trying to exonerate anyone here I am just wondering if there is anything out there that would help them get relief from the situation.

I didn't say you were trying to exonerate anyone, I just opined you have some risk here. More from a client not understanding the implications of signing of a form you sent them, but a misfiling of returns after advice was given could be problematical as well.

Get "relief" from what? They made an election. To overcome the election, you would need to get consent from the commissioner (if he even could), and the usual part of that on accounting methods is that it does not disadvantage the government. Here, there seems a clear disadvantage. So, even if you could theoretically ask for permission, I don't think they will grant it.

The additional tax will be owed. The interest on the tax will be owed. If you can truly make a case the taxpayer didn't intend to or knew what he was doing on making the election, you *might* get the penalties forgiven. That is the only relief I see absent consent of the commissioner--which I don't think you will be able to get.

If the facts indicate a C is still better than an S-corp, I'd make a claim of an invalid election under (f) simultaneous with a termination under (d) to "fix" the problem in the future. If you terminate, you will need a part year return and can't re-elect S status for 5 years. Even if you don't get the (f), you can at least move forward as you like.

Out of curiosity, how long did it take to do the double cash flip to determine liability? (Or, did you just stay cash basis? If so, why so much liability?)

 

[jbauer1626]

The Corporation can stay cash basis. They are not overly large. However it is a farm corporation and the timing of the selling of grains and cattle for tax planning purposes kept the fiscal year end tax liability low but will not for the calendar year end.

 

[tranquility]

You must have booked the income from the sale of the crops in the next year, what happens if you amend to remove the income from there and include it with the S-corp? It seems very unusual to me to have a greater tax burden over time in an S-corp as opposed to a C-corp if we are only talking about cash/accurral issues on a farm. I was thinking there were some suspended losses unavailable in an S from the C, but fiscal versus calendar does not seem to give rise to such liability.

Have you prepared outlying returns based on the IRS claim?

 

[jbauer1626]

It would seem that just switching from an S to a C would not cause an issue however the timing is crucial. The amount of income rises every year but the corresponding expenses are from the prior year so they are not matching up with the income thus causing the problem. We have not actually prepared the returns however we do have the trial balances roughly prepared and it is ugly.

 

[LdiJ]

It would seem that just switching from an S to a C would not cause an issue however the timing is crucial. The amount of income rises every year but the corresponding expenses are from the prior year so they are not matching up with the income thus causing the problem. We have not actually prepared the returns however we do have the trial balances roughly prepared and it is ugly.

Ugly enough that getting rid of any double taxation doesn't help? You won't know how ugly until you prepare the S corp returns and then amend the personal returns.