There are tax implications for just about everything we do. Even simple business transactions present tax opportunities and pitfalls.
While we prefer to focus on tax opportunities, we also spend a lot of time fixing tax problems.
We are in Texas, which is a community property state. So one issue we see over and over again is problems forming business entities. Taxpayers who are married and live in community property states have to do a little more tax planning when forming businesses.
The recent Hong Jun Chan v. Commissioner, T.C. Memo. 2021-136 court case provides an example. The case involves an invalid S corporation election that the U.S. Tax Court blessed.
Facts & Procedural History
The taxpayers are husband and wife. They owned and operated a restaurant in California. They operated the restaurant through a legal entity that was formed in 2010.
In 2011, the taxpayer-husband filed a Form 2553, Election by a Small Business Corporation, to have the entity taxed as an S corporation. The form reported that he owned 100% of the entity.
The taxpayers never filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for the restaurant. They argued that they filed Forms 1120, U.S. Corporation Income Tax Return, for the restaurant. We’ll come back to this point later.
The taxpayers filed a 2015 tax return and did not report any items of income or expense that would have flowed through to their individual income tax return from the S corporation tax return. They did not file an individual tax return for 2016.
The IRS audited their tax return for 2015 and also adjusted 2016. The adjustments resulted in the inclusion of the flow-through income from the restaurant and the allowance for no deductions from the restaurant.
Litigation in the U.S. Tax Court ensued. The taxpayers opted to represent themselves.
About Subchapter S Corporations
The Subchapter S corporation is an income tax classification. The underlying entity is just a corporation formed under state law (it can also be a limited liability company or LLC, but we’ll skip that nuance for this article). Form 2553 is filed with the IRS to make the election.
Absent an election, a corporation is taxed as a corporation for income tax purposes. Corporations report and pay income tax on their income and expenses. The net profit does not flow through to the shareholders. Shareholders do pay tax on any dividends they receive from the corporation (a dividend is just any funds or assets taken out of the entity for the shareholder that are not wages, loans, etc.). This can result in double tax–once at the corporation level and once at the shareholder level for any dividend.
An S corporation election changes this. The net profit flows through to the shareholder’s individual income tax returns. There is no tax on the distributions paid to the shareholders, as they are already taxed on the net profit (there are nuances here, but we are simplifying for this article).
The benefit of the S corporation is that it can avoid the double income tax on distributions from a C corporation (When compared to an LLC that is disregarded and not subject to tax, the S corporation can be used to avoid paying employment taxes on some of the net profit of the entity–this is also beyond the scope of this article).
The One Class of Stock Requirement for S Corps
There are several requirements that have to be met for the S corporation election to remain in place. One of these requirements is that the corporation has one class of stock.
Whether there is a second class of stock is usually evaluated by considering the rights to current and liquidating distributions. Distributions usually have to be equal for each shareholder.
This means that the S corporation cannot have one class of stock (such as A shares) that is entitled to a larger distribution than another class of stock (such as B shares).
A binding agreement to give preference to some shares can terminate the S corporation election. We frequently see this when we review LLC Company Agreements prepared by business attorneys who do not focus on tax planning. The standard company agreement can void an S corporation election. This can even come up in instances where there is a corporation formed in a community property state by just one spouse.
S Corporation Election Signed by One Spouse
Form 2553 has to be signed by all of the owners of the corporation. An election signed by one shareholder is invalid. This is set out in 1362(a)(2).
The regulations address this rule when it comes to spouses in community property states. Specifically, Treasury Regulation 1.1362-6(b)(2)(i) says that both spouses have to sign Form 2553 to make a valid election.
Section 1.1362-6(b)(3)(iii) sets forth the hoops the taxpayer has to jump through to fix this problem.
The process for requesting relief for this is set out in Rev. Proc.2004-35, 2004-23 I.R.B. 1029. This guidance provides for automatic consent from the IRS if certain criteria are met and a ruling request is submitted. The taxpayers, in this case, would not have qualified for this relief as one of the requirements is that the taxpayers filed their income tax returns as if the S corporation election was valid. The taxpayers did not file Forms 1120S in this case.
Filing C Corporation Returns Does Not Matter
This brings us back to this case. Remember the taxpayers opted to represent themselves.
The taxpayers argued that they filed Forms 1120 for a corporation and that this means that the restaurant was not an S corporation. The taxpayers argued that the restaurant was a C corporation and, as a result, the net profit would not flow through to their personal income tax returns.
The tax court did not accept the taxpayers’ argument. The tax court held that the restaurant was an S corporation based solely on the taxpayers’ argument that the filing of a Form 1120 was determinative. Of course, the taxpayers’ argument failed. It does not matter what form the taxpayers filed. That has no bearing on how the entity was to be taxed.
The Court Blessed the S Corporation Election
The taxpayers may have been correct in that the entity was a C corporation. The facts set out in court opinion suggest that the S corporation election was invalid.
The taxpayers lived in a community property state. The taxpayer-wife did not sign the Form 2553 in this case to make the election. There is no evidence that the taxpayers requested late relief to fix this problem. Based solely on the facts in the court’s opinion, it seems like the S corporation election is invalid. The taxpayers’ argument that the entity was a C corporation seems correct.
The facts in the court opinion also suggest that there is a second class of stock problem. The corporation appears to be owned 50 percent by each spouse (or maybe the spouses each owned 20 percent–the result is the same). The taxpayer-husband filed a Form 2553 that shows that the wife has no ownership in the corporation. This would seem to evidence an agreement to allocate more to one shareholder, the husband, than the other shareholder, the wife (indeed the IRS’s allocation to the husband by itself seems to void the S corporation election).
If this is correct, the S corporation election was terminated and the entity was a C corporation for Federal income tax purposes. The taxpayers’ argument about the restaurant being a C corporation would have been correct.
This case provides authority that can be cited by married couples in community property states who inadvertently terminate their S corporation election.
If taxpayers do not want to jump through the hoops set out by the IRS in its guidance for requesting late relief, or if they do not qualify for that relief, they may be able to ignore the IRS’s guidance and, if there is an IRS adjustment on audit, they can just ask the U.S. Tax Court to bless their invalid S corporation election.
For those who are more risk-averse, a better and more conservative strategy might be to just follow the IRS’s guidance. This requires making a request to obtain the IRS’s automatic consent by requesting a letter ruling.