Invalid S elections: Close does NOT count for tax purposes

Subchapter S elections provide a business (S corp) with a tax classification that generates some of the tax benefits of a partnership while preserving the liability protection that is associated with its legal status. Businesses that want to elect Subchapter S status must comply with certain limitations on (1) the number and types of shareholders they can have, and (2) the types of stock they can issue. In some cases, businesses can run afoul of the limitations without realizing it. Those missteps, however unintentional, can prove costly from a tax standpoint.

What are the ramifications?

If the S election was invalid when made or the requirements to maintain an S election were violated during the life of the business, the IRS may treat the taxpayer as if the election was never made or terminated. If it was organized as a C corporation, the target may be liable for unpaid corporate taxes.

An invalidated S election may also have a significant impact on the purchaser’s ability to capitalize on certain favorable tax structuring opportunities.  

An invalidated S election may also have a significant impact on the purchaser’s ability to capitalize on certain favorable tax structuring opportunities. For instance, If the target’s selection is invalid and it’s actually a C corporation, the buyer cannot make a 338(h)(10) election to treat a stock acquisition as an asset acquisition for tax purposes. The 338 election often provides the buyer with significantly larger depreciation deductions in the years after the transaction because it allows a step up in asset basis to fair market value.

What should you look for?

In order to qualify for a Subchapter S election, a business must:

• Be a domestic corporation.
• Permit only individuals, estates, and qualifying trusts as shareholders.
• Have no more than 100 shareholders.
• Issue only one class of stock.
• File a Form 2553 “Election by a Small Business Corporation,” signed by all current shareholders, with the IRS.

If the S corp violates any of the requirements, its S election is invalid or may terminate when the violation occurs. Some common causes of an inadvertent termination include:

• Creation of a second class of stock. This sometimes occurs when a limited liability company (LLC) elects to become an S corp. If the LLC doesn’t have an operating agreement, or if its operating agreement contains typical partnership tax language that may create different allocation or liquidation rights, the LLC might be deemed to have created a second class of stock that invalidated its S election. If the S election is not valid, the company may be classified as a C corporation, partnership, or sole proprietorship depending on its facts.
• Failure to have each shareholder and spouse sign the election if electing in a community property state.

In conclusion

If tax due diligence raises concerns with the target’s Subchapter S status, there may be ways to remedy an invalid or inadvertently terminated S election. Sometimes this may even be done prior to the close of a transaction. If the issue can’t be resolved before the deal closes, the buyer will want to restructure the transaction. If you have any questions, please give us a call.