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S corporations often face challenges with their election status. IRS procedures offer relief, but prompt action is vital to avoid costly issues.
In brief
S corporations often encounter problems with their S elections, which can lead to invalid or terminated status.
The IRS has established several procedures, such as Rev. Proc. 2022-19 and Rev. Proc. 2013-30, to provide relief for common issues.
Corporations must rectify problems promptly to avoid costly consequences.
To be an S corporation is to live dangerously. After all, to be taxed as an S corporation1, the corporation1 must file a complete and timely election with the IRS and meet and maintain strict eligibility requirements. One misstep — either with the procedural requirements of the election or the eligibility rules — and the corporation’s S election immediately terminates.2
But how often do S corporations really have problems with their S elections? Quite often, it turns out. A former attorney with the IRS Office of Chief Counsel stated that when the IRS was developing Rev. Proc. 2013-30 (discussed below), upward of 30,000 S corporations were seeking relief from an invalid or terminated S election each year.3 While in many cases, the IRS will grant automatic relief via a series of revenue procedures it has issued over the decades, when automatic relief is unavailable, an S corporation will have to pay a substantial user fee — $43,700 after Feb. 1, 2025 — and ask the IRS to provide relief in a letter ruling. In 2024 alone (when the fee was $38,000), the IRS issued 148 letter rulings to S corporations seeking relief from an S election that was inadvertently invalid or terminated.
The numbers don’t lie; clearly, there are a lot of things that can go wrong with an S election. This article examines four of the most likely reasons an S election will be invalid when made or terminate, then explains why the S corporation should fix each fatal flaw quickly and how it can do so without having to pay the considerable user fee for a letter ruling.
IRS relief requests in 2024
148
letter rulings were issued by the IRS to S corporations seeking relief from an S election that was inadvertently invalid or terminated.
1
Problem 1
The issue of unequal shareholder rights
Nonidentical governing provisions in a state-law limited liability company (LLC)-turned-S corporation
An S corporation is a “small business corporation” that has an S election in effect for the year at issue.4 A small business corporation is a domestic corporation that does not: (1) have more than 100 shareholders; (2) have as a shareholder a person (other than an estate, certain types of trusts,5 or certain tax-exempt organizations) who is not an individual; (3) have a nonresident alien shareholder; or (4) have more than one class of stock.6
This final requirement has become a significant problem for S corporations in recent years. More specifically, it has become a significant problem for state-law LLCs that elect to be taxed as S corporations for federal tax purposes. To understand why, however, one must first appreciate what the code means when it limits an S corporation to having only a single class of stock.
An S corporation may have voting and nonvoting shares of stock;7 what is critical, however, is that all outstanding shares of stock of the S corporation confer identical rights to distribution and liquidation proceeds.8
In practice, this requirement is often misinterpreted as requiring that an S corporation make all distributions pro rata, but that is not quite how the regulations work. Instead, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the “governing provisions”).9
Stated another way, the regulations generally determine whether an S corporation has a second class of stock by looking not at what a corporation does in making its distributions but rather by what the corporation’s governing provisions say. This creates an interesting dichotomy: On the one hand, as the IRS stated in Section 3.02 of Rev. Proc. 2022-1 9,10 “the IRS will not treat any disproportionate distributions made by a corporation as violating the one class of stock requirement of [Sec.] 1361(b)(1)(D) so long as the governing provisions of the corporation provide for identical distribution and liquidation rights.” On the other hand, as the IRS has determined in many letter rulings, if a corporation’s governing provisions do not confer equal rights to distribution and liquidation proceeds, the corporation’s S election is not valid, regardless of whether it has made every distribution pro rata to the penny.11
X Co., an S corporation, has two shareholders, A and B. On Jan. 1, 2025, A and B enter into a shareholder agreement that provides that because A has moved to a state with a higher state income tax rate than B, A will get a larger distribution each year. The shareholder agreement is a binding agreement related to distribution and liquidation proceeds and thus a governing provision of the S corporation. Because it does not confer equal rights to distributions to A and B, X Co. has a second class of stock, and its S election terminates as of Jan. 1, 2025.
While these types of nonidentical governing provisions are relatively rare in state-law corporations, consider the case of a state-law LLC that elects to be taxed as an S corporation. An LLC generally does not have articles of incorporation, bylaws, or a corporate charter. Rather, the governing provisions of a state-law LLC — the binding agreement relating to distribution and liquidation proceeds — is generally the LLC’s operating agreement. And therein lies the problem.
Many LLC operating agreements are drafted in contemplation of the LLC being taxed as a partnership for federal tax purposes. As a result, the operating agreement may contain standard language that is required by the regulations should the partnership desire to make special allocations of income, gain, loss, or deduction. For example, to comply with the substantial-economic-effect safe harbor of Regs. Sec. 1.704-1 (b)(2), the operating agreement must require the partnership to maintain capital accounts in accordance with the rules of Sec. 704(b)12 and to make liquidating distributions in accordance with the positive balance of the partners’ capital accounts.13
While that language is certainly helpful should the LLC in fact operate as a partnership for federal tax purposes, as the IRS has ruled in a slew of letter rulings over the past decade,14 that same language is fatal the moment the LLC decides to file an S election. This is because requiring the LLC to make liquidating distributions in accordance with capital account balances that are maintained under the rules of Sec. 704(b) does not confer to each shareholder equal rights to liquidating proceeds.
It cannot be overstated how prevalent this problem is; many LLC operating agreements contain this type of nonidentical governing provision, resulting in the LLC’s S election being or becoming invalid15 because the single-class-of-stock requirement is not satisfied.16
Whether the S election is inadvertently invalid when made or is valid for a period of time before subsequently terminating, the IRS has provided numerous automatic relief procedures.
Fix for Problem 1: Rev. Proc. 2022-19
If there is a silver lining to be found in the “nonidentical governing provision” problem that plagues LLCs-turned-S corporations, it is that it has become so common that the IRS decided to offer a path for automatic relief.
Rev. Proc. 2022-19 provides that an S corporation with nonidentical governing provisions will be treated as an S corporation from the adoption date of the first nonidentical governing provision that invalidated or terminated the corporation’s S election if the following four conditions are met:
The corporation has or had one or more nonidentical governing provisions;
The corporation has not made and is not deemed to have made a “disproportionate distribution” to an “applicable shareholder”;
The corporation timely filed a Form 1120-S, U.S. Income Tax Return for an S Corporation, for each applicable tax year, beginning with the tax year in which the first nonidentical governing provision was adopted and through the tax year immediately before the tax year in which the corporation sought corrective relief; and
The S corporation obtains the corporate governing provision statement and the shareholder statement required by Section 3.06(2)(c) of the revenue procedure before the IRS discovers any nonidentical governing provisions.17
For purposes of this second condition, a “disproportionate distribution” is “any distribution (including an actual distribution, a constructive distribution, or a deemed distribution) of property by a corporation with respect to shares of its stock that differs in timing or amount from the distribution with respect to any other shares of its stock.”18 An “applicable shareholder” is any current or former corporate shareholder who owns or owned corporation stock between the time that the nonidentical governing provision was adopted and the date when that provision was removed or modified to ensure it complies with the one-class-of-stock requirement.19
This second condition greatly reduces the ability of an S corporation to utilize Rev. Proc. 2022-1 9, because even a single disproportionate distribution in an S corporation’s past — whether actual or deemed — is enough to preclude the corporation from obtaining automatic relief; instead, the S corporation must pursue relief via the letter ruling process. This rule, which has become known as the “double fault rule,”20 applies even when the disproportionate distribution was not made in compliance with the S corporation’s nonidentical governing provisions.
An LLC elected to be taxed as an S corporation effective Jan. 1, 2022. In 2024, the LLC determined that at the time its S election was made, its operating agreement required it to make liquidating distributions in accordance with the partners’ capital accounts, resulting in nonidentical governing provisions. As a result, the S election was invalid when made on Jan. 1, 2022. In addition, in 2023, the LLC made a disproportionate distribution to its shareholders because one shareholder was subject to a higher state income tax rate. The mere presence of the disproportionate distribution means that the LLC cannot obtain automatic relief under Rev. Proc. 2022-19 and instead must seek relief from its invalid S election by requesting a letter ruling.
2
Problem 2
Late S elections
Many small businesses miss the deadlines to elect S corporation status, but Rev. Proc. 2013-30 provides a pathway for relief.
An eligible small business corporation elects to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation. The statute provides strict time limits for filing the Form 2553 that are often missed.
A newly formed business that intends to be treated as an S corporation upon formation must file Form 2553 on or before the 15th day of the third month of the year for which the election is to be effective.21 For these purposes, the tax year of a new corporation begins on the date that the corporation has shareholders, acquires assets, or begins doing business, whichever is the first to occur.22 A “month” means a period commencing on the same numerical day of any calendar month as the day of the calendar month on which the tax year began, and ending with the close of the day preceding the numerically corresponding day of the succeeding calendar month.23
X Co. begins its first tax year on Jan. 7, 2025. The first “month” begins on Jan. 7 and ends on Feb. 6; the second month ends on March 6; and an additional 15 days brings the date to March 21. Thus, to be an S corporation beginning with its first tax year, the corporation must file Form 2553 on or before March 21, 2025. Because the corporation had no tax year immediately preceding the tax year for which the election is to be effective, an election made earlier than Jan. 7, 2025, will not be valid.24
For an existing corporation, the Form 2553 can be filed at any time during the preceding tax year or during the current tax year, as long as it is filed on or before the 15th day of the third month of the tax year.25
X Co., a calendar-year C corporation, desires to be treated as an S corporation effective Jan. 1, 2025. X Co. may file the Form 2553 at any time in 2024 and on or before March 15, 2025.
The statute provides a safety net for a late election by stating that if a Form 2553 that was intended to be effective on the first day of the tax year is filed after the 15th day of the third month of the tax year but before the 15th day of the third month of the following tax year, the S election is treated as being made for the beginning of the following tax year.26
X Co., a calendar-year C corporation, desires to make an S election effective Jan. 1, 2024. X Co. files the Form 2553 on May 2, 2024. Because the Form 2553 was filed after March 15, 2024 — the 15th day of the third month of the tax year — the election will be treated as being effective Jan. 1, 2025.
It is exceedingly common for an S corporation to discover that it failed to file a timely S election or, in many cases, that the Form 2553 was inadvertently never filed at all, requiring the S corporation to seek relief.
Fix for Problem 2: Rev. Proc. 2013-30
Rev. Proc. 2013-30 has become every S corporation’s best friend, offering a one-stop shop for various forms of relief from late or missed elections. Rev. Proc. 2013-30 allows eligible taxpayers to avoid the private letter ruling process by providing late relief for: (1) S corporation elections, including those made in conjunction with a late entity classification election; (2) electing small business trust (ESBT) and qualified Subchapter S subsidiary trust (QSST) elections (more on these later); and (3) qualified Subchapter S subsidiary (QSub) elections.
Rev. Proc. 2013-30 allows for a late S corporation election when the following circumstances exist: A corporation — or an eligible entity as defined by Regs. Sec. 301.7701-3(a) — intended to be classified as an S corporation as of the desired effective date,27 the election was invalid solely because it was not timely filed,28 and the taxpayer has reasonable cause for its failure to timely file the election and has acted diligently to correct the mistake upon its discovery.29
Rev. Proc. 2013-30 has become every S corporation’s best friend, offering a one-stop shop for various forms of relief from late or missed elections.
Relief from a late S election is generally obtained by filing Form 2553 within three years and 75 days of the desired effective date.30 In certain situations, however, a taxpayer may request relief for a late S corporation election even when more than three years and 75 days have passed since the desired effective date. This can be accomplished only when all the following requirements are met:31
The corporation is not seeking late corporate classification election relief concurrently with a late S corporation election.
The corporation fails to qualify as an S corporation solely because the Form 2553 was not timely filed.
The corporation and all its shareholders reported their income consistent with S corporation status for the year the S election should have been made and for every subsequent tax year (if any).
At least six months have elapsed since the date on which the corporation filed its tax return for the first year the corporation intended to be an S corporation.
Neither the corporation nor any of its shareholders was notified by the IRS of any problem regarding the S corporation status within six months of the date on which the Form 1120-S for the first year was timely filed.
X Co., a state-law corporation that has been filing tax returns as an S corporation since Jan. 1, 2014, discovered in 2025 that it never filed its S election. While Rev. Proc. 2013-30 generally requires that relief be sought within three years and 75 days of the desired effective date of the S election, if X Co. meets the requirements listed above, it can request relief as of Jan. 1, 2014.
Rev. Proc. 2013-30 does not allow a taxpayer to retroactively change its tax status to an S corporation; rather, it merely allows a corporation that has always filed its tax returns as an S corporation — despite having not made a timely filed election — to obtain relief from that late election. As a result, the completed Form 2553 must include statements from all shareholders during the period between the date the S corporation election was to have become effective and the date the completed Form 2553 is filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been filed and for all subsequent years.32
X Co., a calendar-year C corporation, filed a Form 1120, U.S. Corporation Income Tax Return, for tax year 2024. In February 2025, X Co. realizes that it would have preferred to be taxed as an S corporation for 2024. Because the shareholders of X Co. cannot represent that they have reported their income for tax year 2024 consistent with X Co. being an S corporation, X Co. cannot use Rev. Proc. 2013-30 to file a late S election for 2024.
An S corporation has three options for filing the late Form 2553. First, the Form 2553 can be filed separately with the applicable IRS service center if it is filed within three years and 75 days after the effective date.33 If the S corporation has filed all Forms 1120-S for tax years between the effective date and the current year, the election form can be attached to the current-year Form 1120-S, as long as the current-year Form 1120-S is filed within three years and 75 days after the effective date. Finally, in the case of an S corporation that has not filed Form 1120-S for the tax year including the effective date or any year following the effective date, the election form may be attached to the Form 1120-S for the year including the effective date as long as (1) the Form 1120-S for the year including the effective date is filed within three years and 75 days after the effective date and (2) all other delinquent Forms 1120-S are filed simultaneously and consistently with the requested relief.34
It is critical to note that, when including the Form 2553 with the Form 1120-S, an extension of time to file the current-year Form 1120-S will not extend the due date for relief.35
X Co. desired to be taxed as an S corporation effective Jan. 1, 2022. To seek relief under Rev. Proc. 2013-30, X Co. must file the Form 2553 on or before March 17, 2025. If X Co. extends its 2024 tax return to the extended due date of Sept. 15, 2025, this does not extend the deadline for the Form 2553 as part of Rev. Proc. 2013-30. As a result, if X Co. desires to extend its 2024 return, the Form 2553 will need to be separately filed by March 17, 2025.
3
Problem 3
Ineligible trust shareholders
Trusts that do not meet eligibility requirements can terminate an S corporation's election, resulting in unfavorable tax consequences.
As noted in the discussion of Problem 1, only certain types of trusts can be S corporation shareholders.36 Specifically, the following trusts are eligible to hold stock in an S corporation:
A trust all of which is treated (under Subpart E of Part I of Subchapter J of Chapter 1 of the code) as owned by an individual who is a citizen or resident of the United States (a grantor trust)37
A trust that was a grantor trust immediately before the death of the deemed owner and that continues in existence after such death, but only for the two-year period beginning on the day of the deemed owner’s death38
A trust with respect to stock transferred to it pursuant to the terms of a will, but only for the two-year period beginning on the day on which such stock is transferred to it (a testamentary trust)39
A trust created primarily to exercise the voting power of stock transferred to it (a voting trust)40
ESBTs (electing small business trusts)41
In the case of a corporation that is a bank or a depository institution holding company, a trust that constitutes an individual retirement account (IRA) under Sec. 408(a), including one designated as a Roth IRA under Sec. 408A42
QSSTs (qualified Subchapter S subsidiary trusts)43
Problems with trusts as eligible S shareholders generally come in two categories: eligibility and elections.
Eligibility problems routinely plague grantor trusts, ESBTs, and QSSTs. Each type of trust must satisfy the statutory and regulatory requirements necessary to qualify as the type of eligible S corporation shareholder it intends to be.
To meet the definition of a grantor trust, the trust document must contain at least one of the powers listed in Secs. 671 through 678 necessary to cause the trust to be treated as being owned by an individual (whether or not the grantor).44
To qualify as an ESBT, the trust may have multiple income beneficiaries but may not have as a beneficiary any person other than an individual, estate, or certain charitable organizations.45 In addition, no interest in the trust can have been acquired by purchase.46 An ESBT cannot be any of the following: (1) a trust that has made a QSST election; (2) a tax-exempt trust; or (3) any charitable remainder annuity trust or charitable remainder unitrust (as defined under Sec. 664(d)).47
To meet the requirements of a QSST, all of the income of the trust must be distributed (or required to be distributed) currently to one individual who is a citizen or resident of the United States. Additionally, the trust’s terms must require that: (1) during the life of the current-income beneficiary, there is only one income beneficiary of the trust; (2) any corpus distributed during the life of the current-income beneficiary must be distributed only to such beneficiary; (3) the income interest of the current-income beneficiary in the trust must terminate on the earlier of such beneficiary’s death or the termination of the trust; and (4) upon the termination of the trust during the life of the current-income beneficiary, the trust must distribute all of its assets to such beneficiary.48
For ESBTs and QSSTs, merely meeting the statutory requirements necessary to qualify as the intended type of trust is not enough; rather, ESBTs and QSSTs must also file an additional election with the IRS, and as with any tax election, there are procedural requirements that can prove problematic. Specifically, both ESBTs and QSSTs must file an election to be recognized as an ESBT or QSST within the 16-day-and-two-month period beginning on the day on which the trust acquires the stock in the S corporation.49 An ESBT election must include the information required by Regs. Sec. 1.1361-1 (m)(2)(ii), while a QSST election must include the information required by Regs. Sec. 1.1361-1 (j)(6)(ii).
On May 1, 2024, a trust that meets all the requirements to be an ESBT acquires stock in X Co., an S corporation. The trust must file the ESBT election no later than July 16, 2024, the end of the 16-day-and-two-month period beginning on the date the trust acquired the stock.
The regulations contain the following nuances specific to the election timing rules that often catch S corporations off guard.
If an ESBT or QSST owns shares of stock in a corporation that makes an S election retroactive to the first day of the year, the trust must make its election within the 16-day-and-two-month period of the first day of the year.50
A trust that satisfies the requirements to be a QSST owns stock in a corporation. On Feb. 1, 2025, the corporation files an S election effective Jan. 1, 2025. The trust must make the QSST election no later than March 16, 2025, the end of the 16-day-and-two-month period beginning on the date the S election was effective.51
If an ESBT or QSST owns shares of stock in a corporation that makes an S election effective for the first day of the following tax year, the trust must make its election within the 16-day-and-two-month period beginning on the day the S election is filed.52
A trust that satisfies the requirements to be a QSST owns stock in a corporation. On April 1, 2025, the corporation files an S election to be effective Jan. 1, 2026. The trust must make the QSST election no later than June 16, 2025, the end of the 16-day-and-two-month period beginning on the date the S election was filed.53
While the timing requirements governing ESBT and QSST elections are generally the same, there are some important procedural differences. For example, while the trustee of an ESBT must sign the ESBT election,54 the current-income beneficiary of a QSST must sign the QSST election.55 A QSST that is making an election simultaneous with an S election may make the election directly on Form 2553, Part III;56 in contrast, an ESBT will always have to file its election as a separate statement. Finally, while only one ESBT election is made for a trust, regardless of the number of S corporations whose stock is owned by the trust,57 a QSST must make a separate election for each S corporation owned by the trust.58
A trust that satisfies the requirements to be a QSST receives stock in X, an S corporation, on Jan. 1, 2024. The trust must make the QSST election no later than March 16, 2024, the end of the 16-day-and-two-month period beginning on the date the QSST acquired the stock in X. On Jan. 1, 2025, the trust acquires stock in Y, another S corporation. The trust must make a separate QSST election with respect to the shares in Y no later than March 16, 2025, the end of the 16-day-and-two-month period beginning on the date the QSST acquired the stock in Y. Had the trust been an ESBT rather than a QSST, the trust would need to make only one ESBT election — when it receives the stock in X — no later than March 16, 2024. An ESBT need not make another ESBT election when it acquires the stock in Y.
ESBT and QSST elections are often missed after the expiration of the two-year grace period during which a grantor trust (after the death of the grantor) and a testamentary trust are treated as eligible S corporation shareholders. It is very common for these types of trusts to intend to qualify as an ESBT or QSST after the two-year grace period is over, only to lose track of the expiration of the grace period and fail to make the appropriate election before the due date. This results in an ineligible shareholder and termination of the S election.
F owns the stock of Corporation P, an S corporation. In addition, F is the grantor of Trust A, a grantor trust, that holds stock in Corporation O, an S corporation. F dies on July 1, 2023. Trust A continues in existence after F’s death but is no longer a grantor trust. Trust A will be an eligible S corporation shareholder until June 30, 2025, the last day of the two-year period that begins on the date of F’s death. Assuming that Trust A meets the definition of a QSST as of June 30, 2025, Trust A must make the QSST election no later than Sept. 16, 2025, the end of the 16-day-and-two-month period beginning on July 1, 2025, the date on which Trust A’s two-year grace period has expired and Trust A would otherwise become an ineligible S corporation shareholder.59
On Aug. 1,2023, F’s shares of stock in Corporation P are transferred to Trust B pursuant to the terms of F’s will. With respect to the stock in Corporation P, Trust B is a testamentary trust and, as a result, is an eligible S corporation shareholder until July 31, 2025, the last day of the two-year period that begins on the date of the transfer from F’s estate to the trust. Assuming that as of Aug. 1, 2025, Trust B meets the definition of an ESBT, the trust must file its ESBT election no later than Oct. 16, 2025, the end of the 16-day-and-two-month period beginning on Aug. 1, 2025, the date on which Trust B’s two-year grace period as a testamentary trust expires and Trust B would otherwise become an ineligible S shareholder.
A common misconception is that a grantor trust that voluntarily turns off grantor status and becomes a nongrantor trust is afforded a two-year grace period as an eligible S corporation shareholder. This is not the case. As a result, the nongrantor trust must immediately meet the definition of either a QSST or an ESBT and make the appropriate election before the expiration of the 16-day-and-two-month period beginning on the date the trust became a nongrantor trust.60
A is the grantor of Trust C, a grantor trust, that holds stock in X Co., an S corporation. On May 1, 2025, A relinquishes his grantor powers, and Trust C becomes a nongrantor trust. Trust C must immediately qualify as a QSST or ESBT and must make the appropriate election no later than July 16, 2025, the end of the 16-day-and-two-month period beginning on the date Trust C became a nongrantor trust.
Fix for Problem 3: Rev. Proc. 2013-30
When an ESBT or QSST election is not timely filed, the trust is an ineligible shareholder and the corporation’s S election terminates as of the day the trust acquired the stock. Fortunately, Rev. Proc. 2013-30 is once again available to provide automatic relief in certain situations.
To obtain relief for a late ESBT or QSST election, the following requirements must be met:61
The trustee seeking a late ESBT election or the trust beneficiary seeking a late QSST election must have intended the trust to be an ESBT or QSST, respectively, as of the desired effective date.
The failure to qualify as an ESBT or QSST was solely because the election was not timely filed.
The failure to file the timely election was inadvertent, and the person seeking relief acted diligently to correct the mistake upon discovery.62
An ESBT or QSST can make a late election by filing the appropriate election form63 within three years and 75 days of the desired effective date.64 Unfortunately, as opposed to late S elections,65 there is no opportunity to extend the relief period beyond three years and 75 days.
Trust A, which satisfies the requirements to be an ESBT, received shares of S corporation stock on Jan. 1, 2021. Trust A intended to file its ESBT election prior to March 16, 2021, but the election was never filed. Trust A discovers the problem on June 6, 2024. Because Trust A discovered the mistake after March 18, 2024 — the date that is three years and 75 days after the desired effective date of the ESBT election — Trust A may not seek relief from the late ESBT election using Rev. Proc. 2013-30; instead, relief must be sought via the private letter ruling process.
If, instead, Trust A did not receive the ESBT shares until Jan. 1, 2022, and the missed election was discovered on June 6, 2024, Trust A would have until March 17, 2025, to file the ESBT election and seek relief using Rev. Proc. 2013-30.
The late ESBT election must include: (1) a statement from the trustee of the ESBT that includes the information required by Regs. Sec. 1.1361-1(m)(2)(ii)66 and (2) a statement from the trustee that all potential current beneficiaries meet the shareholder requirements of Sec. 1361(b)(1) and that the trust satisfies the requirements of an ESBT under Sec. 1361(e)(1) other than the requirement to make an ESBT election.67
The late QSST election must include: (1) a statement from the current beneficiary of the QSST that includes the information required by Regs. Sec. 1.1361-1(j)(6)(ii)68 and (2) a statement from the trustee that the trust satisfies the QSST requirements of Sec. 1361(d)(3) and that the income distribution requirements have been and will continue to be met.69
Both elections must include statements from all shareholders during the period between the date the S corporation election was to have become effective or was terminated and the date the completed ESBT or QSST election is filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and for all subsequent years.70
Upon receipt of a completed request for relief under the revenue procedure, the IRS will determine whether the requirements for granting additional time to file the election have been satisfied and will notify the requesting party of the result of this determination.
4
Problem 4
Missing shareholder consents in a community property state
All shareholders, including those who owned stock during the relevant period, must provide detailed consent.
As discussed in Problem 2, it is not uncommon for an S corporation to fail to file a timely S election, forcing the S corporation to seek relief. There are more concerns when filing a Form 2553, however, than merely filing prior to the due date. Regulations provide that an S election is not valid unless all shareholders of the corporation at the time of the election consent to the election,71 a requirement that has proven to be a frequent problem area for S corporations.
A proper consent requires not only the signature of the shareholder but also the shareholder’s name, address, and taxpayer identification number; the number of shares of stock owned by the shareholder; the date (or dates) on which the stock was acquired; the date on which the shareholder’s tax year ends; the name of the S corporation; the corporation’s taxpayer identification number; and the election to which the shareholder consents. The consent must be signed by the shareholder under penalties of perjury.72
S corporations often fail to identify which shareholders must consent to the election. For example, when an S election is made retroactive to the beginning of the year, all shareholders who owned stock at any point from the desired effective date through the date the Form 2553 is filed must consent to the election, even if the shareholder does not own stock on the day the election is filed.73
On Jan. 1, 2024, A, B, and C own shares of X Co., a corporation. On Feb. 1, 2024, A sells his stock to D. On March 1, 2024, when B, C, and D are the only shareholders of X Co., the corporation elects to be taxed as an S corporation effective Jan. 1, 2024. For the election to be valid, the Form 2553 must include the consent of B, C, D, and even A. Even though A was not a shareholder as of March 1, 2024, because A owned stock in X Co. between Jan. 1, 2024, and March 1, 2024, A must consent to the election.
An S corporation must also identify who is required to consent on behalf of each shareholder. The consent of an estate must be made by an executor or administrator thereof, or by any other fiduciary appointed by testamentary instrument or appointed by the court having jurisdiction over the administration of the estate.74 In the case of a trust shareholder, who must consent to the election depends on the nature of the trust: For a grantor trust, the deemed owner must consent;75 for an ESBT, the consent must be made by the trustee;76 and in the case of a QSST, the income beneficiary must consent.77
The most frequent trap in recognizing who must consent to an election belongs not to an estate or trust, however, but rather to married individuals who reside in certain states. Regulations require that when stock of an S corporation is owned by a husband and wife as community property (or the income from the stock is community property) or is owned by tenants in common, joint tenants, or tenants by the entirety, each person having a community interest in the stock and each tenant in common, joint tenant, and tenant by the entirety must consent to the election.78 The consent of a spouse is frequently missed in the nine community property states (i.e., Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin).
The consent of a spouse is frequently missed in the nine community property states.
A and B are married and reside in Texas, a community property state. A owns stock in X, a C corporation. Effective Jan. 1, 2024, X Co. elects to be taxed as an S corporation. Because A and B reside in a community property state, even though only A directly owns stock in X Co., B has a state-law community property interest in the stock and must also consent to X Co.’s S election. Failure to do so means that X Co.’s S election was invalid.
Fix for problem 4: Rev. Proc. 2004-35
An S corporation that discovers that its S election was invalid because of the failure to obtain all required consents has three possible paths for relief before needing to request a letter ruling.
First, the S corporation can seek relief under Regs. Sec. 1.1362-6(b)(3)(iii), which allows the corporation to request an extension of time from the IRS to obtain a required consent. The S corporation must establish that there was reasonable cause for the failure to file the consent, the request for the extension of time to file a consent must be made within a reasonable time under the circumstances, and the interests of the government cannot be jeopardized by treating the election as valid. This option for relief does not have a time limit but is not automatic; the S corporation must request the extension of time from the IRS and hope that it is granted.
Next, Rev. Proc. 2022-19 instructs an S corporation with a missing consent to fix the problem using Rev. Proc. 2013-30. Historically, practitioners had debated whether relief under Rev. Proc. 2013-30 was limited to circumstances in which an election was simply missed or filed late, as discussed in Problem 2. This debate was put to rest by Section 3.03(1)(b) of Rev. Proc. 2022-19, in which Treasury and the IRS specifically provided that taxpayers may seek relief under Rev. Proc. 2013-30 when otherwise applicable, in circumstances where an election was invalid because of a missed shareholder consent. Presumably, the S corporation would need to seek relief from a missing consent within three years and 75 days of the desired effective date of the S election unless the S corporation meets the requirements in Section 5.04 of Rev. Proc. 2013-30 to go beyond the three-years-and-75-days lookback period.
Finally, for the all-too-common problem of a missing spousal consent in a community property state, relief is available under Rev. Proc. 2004-35, which provides automatic relief79 if: (1) 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 by reason of state community property law and (2) both spouses have reported all items of income, gain, loss, deduction, or credit consistent with the S corporation election on all affected federal income tax returns.
Relief is sought by filing with the IRS service center with which the corporation files its income tax return a dated statement, signed by each spouse under penalties of perjury, that includes the following information:
A representation that reads, “This statement is being furnished pursuant to Rev. Proc. 2004-35 for a late filing of shareholder consents for community property spouses of S corporation shareholders in community property states.”
The name of the corporation, its employer identification number, its address, date of incorporation, state of incorporation, and the intended effective date of its initially filed Form 2553.
Each spouse’s name, Social Security number or employee identification number, tax year end, and the total number of shares owned at the date of the intended election.
A statement that the community property spouses reported all items of income, gain, loss, deduction, or credit consistent with the S corporation election on all affected returns.
The IRS will notify the shareholder of the acceptance or denial of the shareholder’s request to file the late shareholder consent.
A and B are married and reside in Texas, a community property state. A owns stock in X Co., a corporation. Effective Jan. 1, 2004, X Co. elects to be taxed as an S corporation. Because A and B reside in a community property state, even though only A directly owns stock in X Co., B has a state-law community property interest in the stock and must also consent to X Co.’s S election. Failure to do so means that X Co.’s S election was invalid. X Co. discovers the failure in 2024. X Co. may obtain automatic relief by filing a statement with the IRS that meets the requirements of Rev. Proc. 2004-35.
When all else fails
As this article illustrates, S corporations frequently discover that their S elections were inadvertently invalid or terminated. Fortunately, Rev. Procs. 2022-1 9, 2013-30, and 2004-35 provide automatic relief procedures that allow an S corporation to fix many of the most common procedural and eligibility problems.
As discussed above, however, there are limits to the relief offered by these revenue procedures. A state-law LLC that elected to be taxed as an S corporation may discover that it has both nonidentical governing provisions and a history of disproportionate distributions, knocking it outside the purview of Rev. Proc. 2022-1 9. An ESBT may discover that it failed to file an ESBT election more than three years and 75 days after the intended effective date, making it too late to seek relief under Rev. Proc. 2013-30. Or an S corporation may realize that it did not obtain the consent of a shareholder who is now deceased or otherwise unreachable, meaning that Rev. Procs. 2013-30 and 2004-35 will be of no help.80
Fortunately, the statutes provide two forms of additional recourse for those S corporations that cannot obtain automatic relief from an inadvertently invalid or terminated S election.
First, Sec. 1362(b)(5) permits the IRS to treat a late S election as timely if the IRS determines that there was reasonable cause for the late filing. As a result, an S corporation that discovers that it filed a late election but that is outside the relief provisions of Rev. Proc. 2013-30 may obtain relief under Sec. 1362(b)(5) by requesting a letter ruling. The IRS has granted relief pursuant to Sec. 1362(b)(5) in hundreds of rulings over the years.81
Second, for all other inadvertently invalid or terminated S elections — e.g., those related to an impermissible second class of stock, ineligible shareholders, or a missing consent — Sec. 1362(f) allows the IRS to waive the invalid or terminated S election in a letter ruling.
Sec. 1362(f) provides that a corporation will be treated as an S corporation even if its election was not effective for the tax year at issue because it failed to meet the requirements under Sec. 1361(b) or to obtain shareholder consents or was terminated, if three requirements are met:
The circumstances that caused the ineffectiveness or termination were inadvertent.82
Within a reasonable period of time after discovering the problem, the entity took steps to correct it.83
The corporation and each of its shareholders agree to make adjustments that the Treasury secretary may require.84
Just as is the case with late S election relief under Sec. 1362(b)(5), the IRS has granted relief from invalid or inadvertently terminated S elections under Sec. 1362(f) in hundreds of rulings over the past decades.85
The letter ruling process offers S corporations a valuable safety net, but as noted at the outset of this article, it is a costly one. An S corporation requesting relief under either Sec. 1362(b)(5) or Sec. 1362(f) must pay a user fee of $43,700 for requests received after Feb. 1, 2025.86
Protect your clients
Practitioners must be diligent in reviewing their S corporation clients to ensure any S elections were not inadvertently invalid or terminated. The benefit in doing so is obvious: Automatic relief may be available if the problematic elections are identified in a timely fashion. If a problem is not discovered until too late, however — for example, a late ESBT or QSST election may be discovered more than three years and 75 days after the desired effective date, rendering Rev. Proc. 2013-30 inapplicable — the only option for repairing the election is the letter ruling process.
Automatic relief may be available if the problematic elections are identified in a timely fashion. If a problem is not discovered until too late, however, the only option for repairing the election is the letter ruling process.
As a result, it is critical for practitioners to regularly review the problem areas identified in this article. Does the operating agreement for a state-law LLC contain nonidentical governing provisions? Did any ESBT or QSST shareholders file a timely election? Is there a copy of the executed Form 2553, and if so, does it contain the necessary consents and was it timely filed?
Upon unearthing a terminated election, a practitioner may be tempted to question whether it truly needs to be fixed; after all, the practitioner may argue, each year the client files a Form 1120-S with the IRS, and each year the return is accepted by the IRS.
What the practitioner must appreciate, however, is that discovering terminated S elections is not strictly the domain of the IRS. Consider this situation: An S corporation client has spent decades building something of value, and now another party has shown interest in purchasing the S corporation. If the purchase price is large enough, the potential buyer will likely commission an accounting or law firm to perform due diligence on the S corporation target, and the first order of business for that diligence team will be to assess the validity of the target’s S election.87
Should the diligence team find a fatal flaw in the target’s S election, the buyer will likely request that the target provide an indemnity or escrow for potential corporate-level tax liabilities for all years of the target when the S election was invalid and that remain open by statute. This will add an additional challenge to what is likely an already intricate negotiation.
To avoid this uncomfortable moment, practitioners should remedy a client’s terminated S elections as expeditiously as possible. Furthermore, to provide comfort to a potential buyer’s diligence team that the client’s S election is in order, the practitioner should maintain copies of the following records in the S corporation’s permanent file:
The signed, dated, and executed Form 2553;88 Form 8869, Qualified Subchapter S Subsidiary Election; and ESBT and QSST elections, as applicable
Any articles of incorporation, bylaws, shareholder agreements, or operating agreements
The trust documents for any trust shareholders
Risk, but with remedies
As this article illustrates, much can go wrong with an election to be taxed as an S corporation. But whether the S election is inadvertently invalid when made or is valid for a period of time before subsequently terminating, the IRS has provided numerous automatic relief procedures that allow the S corporation to repair the election without the need for a costly letter ruling.
As published by the Tax Adviser, May 31, 2025.
1 This includes any eligible entity that has elected to be taxed as a corporation for federal tax purposes under the check-the-box regulations of Regs. Sec. 301.7701-3. 2 Whether the taxpayer reverts to a C corporation, multimember partnership, or disregarded entity after the termination of its S election depends on the specific facts. For a state-law corporation or an entity that has filed a Form 8832, Entity Classification Election, to be taxed as a corporation for federal tax purposes, termination of an S election will cause the taxpayer to become a C corporation. However, the check-the-box regulations allow an unincorporated entity to elect to be treated as an S corporation without first filing a Form 8832 to be taxed as a corporation. If an unincorporated entity elects to be taxed as an S corporation without separately filing a Form 8832, the entity is deemed to have made a check-the-box election to be taxed as a corporation for federal tax purposes under Regs. Sec. 301.7701-3(c)(1)(v)(C). This deemed entity classification election, however, is only valid if the entity was eligible to make the S election. Thus, if an unincorporated entity goes directly to making an S election without first filing a Form 8832 and the election is determined to be invalid when made, the entity should revert to being treated as a disregarded entity or multimember partnership, depending on the number of owners. 3 Keller, Kirk, and Nitti,” Reflections on the 10th Anniversary of Rev. Proc. 2013-30,” 181 Tax Notes Federal 69 (Oct. 2, 2023). 4 Sec. 1361(a)(1). 5 Discussed more fully later in this article. 6 Sec. 1361(b)(1). 7 Sec. 1361(c)(4). 8 Regs. Sec. 1.1361-1(l)(1). 9 Regs. Sec. 1.1361-1(l)(2)(i). 10 Also see IRS Letter Rulings 202203004 and 201608006. 11 See IRS Letter Rulings 201815003, 201819003, 201840004, 201904001, and 202042001. 12 Regs. Sec. 1.704-1(b)(2)(ii)(b)(1). 13 Regs. Sec. 1.704-1(b)(2)(ii)(b)(2). 14 See IRS Letter Rulings 201815003, 201819003, 201840004, 201904001, and 202042001. 15 The S election would “become invalid” if the offending operating agreement was adopted after the S election was already in effect. 16 See footnote 2. Regs. Sec. 301.7701-3(c) provides that a state-law LLC that elects to be taxed as an S corporation is deemed to have made a check-the-box election, but only if the LLC was eligible to make the S election. Because, in the case of bad governing provisions in the operating agreement, the election was never valid, in the absence of a separate check-the-box election to be taxed as a corporation, the entity should revert to being treated as a disregarded entity or partnership for federal tax purposes, depending on the number of owners. 17 Examples of each statement are provided in Appendices A and B of Rev. Proc. 2022-19. Interestingly, the statements are not mailed to the IRS or attached to the Form 1120-S but rather are simply retained as part of the corporation’s records. 18 Rev. Proc. 2022-19, §2.03(2). 19 Rev. Proc. 2022-19, §3.06(1)(a). 20 The term “double fault” refers to the fact that the S corporation has both adopted a nonidentical governing provision and made a disproportionate distribution. 21 Regs. Sec. 1.1362-6(a)(2)(ii)(A). 22 Regs. Sec. 1.1362-6(a)(2)(ii)(C). 23 Id. 24 Regs. Sec. 1.1362-6(a)(2)(iii), Example 1. 25 Sec. 1362(b)(1); Regs. Sec. 1.1362-6(a)(2)(ii)(A). 26 Sec. 1362(b)(2); Regs. Sec. 1.1362-6(a)(2)(ii)(B). 27 Rev. Proc. 2013-30, §4.02(1). 28 Rev. Proc. 2013-30, §4.02(3). 29 Rev. Proc. 2013-30, §4.03(1). To satisfy this final requirement, the corporation must include in its late election a “reasonable cause” statement, signed under penalties of perjury, that describes its reasonable cause for failure to timely file the election and its diligent actions to correct the mistake upon its discovery. 30 Rev. Proc. 2013-30, §4.02(2). The Form 2553 must be signed by an officer of the corporation and all persons who were shareholders at any time during the period that began on the first day of the tax year for which the election is to be effective and ends on the day the completed Form 2553 is filed. The Form 2553 must state at the top of the document “Filed pursuant to Rev. Proc. 2013-30.” 31 Rev. Proc. 2013-30, §5.04. 32 Rev. Proc. 2013-30, §5.02. 33 Rev. Proc. 2013-30, §4.03(2)(c). 34 Rev. Proc. 2013-30, §4.03(2). Upon receipt of a completed request for relief under the revenue procedure, the IRS will determine whether the requirements for granting additional time to file the election have been satisfied and will notify the requesting party of the result of this determination. 35 Rev. Proc. 2013-30, §4.03(2). Also note that, pursuant to Rev. Proc. 2018-58, the due date for a relief request under Rev. Proc. 2013-30 is not extended in disaster relief situations. 36 Sec. 1361(b)(1)(B). 37 Sec. 1361(c)(2)(A)(i). 38 Sec. 1361(c)(2)(A)(ii). 39 Sec. 1361(c)(2)(A)(iii). 40 Sec. 1361(c)(2)(A)(iv). 41 Sec. 1361(c)(2)(A)(v). 42 Sec. 1361(c)(2)(A)(vi). 43 Sec. 1361(d). 44 Regs. Sec. 1.1361-1(h)(1)(i). 45 Sec. 1361(e)(1)(A)(i). 46 Sec. 1361(e)(1)(A)(ii). 47 Sec. 1361(e)(1)(B). 48 Regs. Sec. 1.1361-1(j)(1). 49 Regs. Secs. 1.1361-1(j)(6)(iii) and 1.1361-1(m)(2)(iii). 50 Regs. Sec. 1.1361-1(j)(6)(iii)(B). 51 Regs. Sec. 1.1361-1(k)(1), Example (9)(i). 52 Regs. Sec. 1.1361-1(j)(6)(iii)(B). 53 Regs. Sec. 1.1361-1(k)(1), Example (9)(ii). 54 Regs. Sec. 1.1361-1(m)(2). 55 Regs. Sec. 1.1361-1(j)(6)(ii). 56 A QSST that acquires stock after the S election is made must file the QSST election as a separate statement. 57 Regs. Sec. 1.1361-1(m)(2)(i). Note, however, that if the ESBT holds stock in multiple S corporations that file in different IRS service centers, the ESBT election must be filed with all the relevant IRS service centers where the corporations file their income tax returns. 58. Regs. Sec. 1.1361-1(j)(6)(i). 59 Regs. Sec. 1.1361-1(k)(1), Example (3). Also note that if a grantor trust, after the death of the grantor, meets the definition of an ESBT or QSST before the end of the two-year grace period, the trust may make the ESBT or QSST election, as appropriate, at any time during the two-year grace period but must make the election no later than the end of the 16-day-and-two-month period beginning on the date the two-year grace period ends. The same is true for the two-year grace period afforded a testamentary trust. See Regs. Sec. 1.1361-1(j)(6)(iii)(D) and Regs. Sec. 1.1361-1(m)(2)(iv). 60 Regs. Sec. 1.1361-1(j)(6)(iii)(C). 61 Rev. Proc. 2013-30, §4.02(2). 62 As a result, both a late ESBT and a late QSST election must include an “inadvertence statement” explaining that the failure to file the election was inadvertent and the diligent actions undertaken to correct the mistake upon its discovery. 63 The election must be signed by the trustee of an ESBT or the current-income beneficiary of a QSST. In the case of a late ESBT election, no standard form exists. As a result, the relief is requested on a taxpayer-prepared statement. If a late QSST election is made for a QSST that owned shares at the time of the intended S corporation election, the beneficiary of the QSST can file for late relief using Form 2553 and must complete the QSST election in Part III. However, if the trust acquired shares after a valid election had been made, the trustee must file the election on a taxpayer-prepared statement. 64 Rev. Proc. 2013-30, §4.02(2). 65 See the discussion in “Fix for Problem 2.” 66 Rev. Proc. 2013-30, §6.01(1). 67 Rev. Proc. 2013-30, §6.01(3). 68 Rev. Proc. 2013-30, §6.01(1). 69 Rev. Proc. 2013-30, §6.01(2). 70 Rev. Proc. 2013-30, §6.01(4). 71 Regs. Sec. 1.1362-6(a)(2). 72 Regs. Sec. 1.1362-6(b)(1). Page 2 of Form 2553 allows a shareholder to enter all of the information required by the regulations. 73 Regs. Sec. 1.1362-6(b)(3). 74 Regs. Sec. 1.1362-6(b)(2)(iii). 75 Regs. Sec. 1.1362-6(b)(2)(iv). 76 Id. 77 Id. 78 Regs. Sec. 1.1362-6(b)(2)(i). 79 As authorized by Regs. Sec. 1.1362-6(b)(3)(iii). 80 It is important to note that each of these revenue procedures requires that the problem being addressed by its automatic relief procedures is the only problem with the S election. As a result, if an S corporation has multiple problems with its S election — e.g., nonidentical governing provisions and a missing spousal consent in a community property state — the S corporation cannot independently use Rev. Proc. 2022-19 to fix the former and Rev. Proc. 2004-35 to fix the latter. Instead, the S corporation must request a letter ruling to fix both problems simultaneously. 81 E.g., IRS Letter Rulings 201507021, 201502004, 201614025, 201728016, 201845028, 201921006, 202048004, and 202249003. 82 Sec. 1362(f)(2). 83 Sec. 1362(f)(3). 84 Sec. 1362(f)(4). 85 E.g., IRS Letter Rulings 202207007, 202210002, 202219005, 202223006, 202231009, and 202302004. 86 The user fee is set each year by the first revenue procedure of the year; i.e., Rev. Proc. 2025-1 for 2025. 87 A buyer would want to know if a target’s S election is valid for a variety of reasons, including whether it is possible for the buyer to obtain a step-up in the basis of the assets of the target via a Sec. 338(h)(10) election or whether the buyer may be inheriting corporate-level tax liabilities for years in which the target’s S election was invalid, making the target a C corporation for those years. 88 While the IRS will issue an S corporation a CP261 letter as proof of the service’s acceptance of its S election, the CP261 simply means the election was processed and accepted; it does not mean it was valid. As a result, an S corporation should always retain a copy of its executed Form 2553.
Summary
S corporations must navigate various challenges to maintain their S election status. The IRS has established several procedures, such as Rev. Proc. 2022-19 and Rev. Proc. 2013-30, to provide relief for common issues. However, corporations must act promptly to rectify any problems to avoid costly consequences.
If you are company that took on private equity capital, you need to get up to speed on Section 1202 and 1045 to make sure you monitor the requirements.
