In criminal law, second-degree murder charges can arise from negligent conduct that causes death. Similarly, the “murder” of an S corporation’s tax status often occurs through the negligent inaction of tax accountants and estate lawyers, leading to the inadvertent termination of its S-corporation status.
This termination “kills” the S corporation’s pass-through taxation feature, only for the entity to be “resurrected” as a C corporation, burdened with double taxation liabilities. The term “resurrected” is used deliberately to evoke the unintended revival of a previous C corporation.
An S corporation is not a type of entity formed under state law, but rather a tax election made by a corporation (or LLC). The election is made by filing IRS Form 2553. A valid election transforms the entity from a regular C corporation — subject to double taxation (explained below) — into a pass-through entity for federal income tax purposes (an S corporation in this case). A pass-through entity is an entity that does not pay income tax on its net profits. Rather, its profits are passed-through to its shareholders in proportion to their percentage stock interests in the corporation and reported as income on their individual income tax returns.
Once a corporation reverts back to its initial status as a C corporation, severe tax consequences occur. Meaning, after the “death” of a corporation’s S status, it is as if the corporation is brought back to life in a less desirable form.
This article dissects the financial consequences of negligently failing to make a timely election to maintain S corporation status after the death of a shareholder, explores remedial measures for late elections. Specifically, we discuss the Qualified Subchapter S Trust (QSST) election and the Electing Small Business Trust (ESBT) election, and look at the costly private letter ruling (PLR) process to highlight this pervasive issue.
The S Corporation: A Fragile Entity
S corporations, valued for their pass-through taxation under Internal Revenue Code (IRC) Section 1361, avoid the double taxation of C corporations, where income is taxed at the corporate level (21% federal rate and 8.84% rate (California)) and further taxed upon distribution of dividends to shareholders (up to 23.8% federal with net investment income tax and up to 13.3% state (California)).
To maintain S corporation status, the entity must comply with the following strict rules:
- no more than 100 shareholders,
- one class of stock,
- no disproportionate distribution of profits,
- eligible shareholders (a S corporation my only be owned by individuals, estates, or specific trusts like QSSTs or ESBTs).
A shareholder’s death can jeopardize this S status when his/her stock transfers to an ineligible shareholder. That transfer can occur by law upon the death of a shareholder if the stock is owned by a living trust. Alternatively, if the deceased shareholder had no trust, the stock automatically becomes an asset of his/her estate, which is another form of transfer.
The Crime Scene: Negligent Homicide of S Status
Similar to the negligence that leads to a second-degree murder charge, where reckless disregard of ones actions foreseeably leads to death, the inadvertent termination of an S corporation election often results from tax or estates professionals’ failure to inform a client of the need to make a timely QSST or ESBT election.
When a shareholder dies, his/her stock may pass to a trust or to a probate estate (if there is no trust). If the beneficiary/trustee does not file a timely election with the IRS to qualify as a QSST or ESBT within two months and 16 days of the stock transfer (death), the trust/estate becomes an ineligible shareholder, terminating the S election as of the date that is 2 years after the death of the shareholder.
Congress gave trusts and estates a 2 year window to wrap up the legal and financial affairs of the trust/estate without enduring the severe financial consequences of the termination of a corporation’s S status. However, in doing so, Congress assumed that S corporations are 100% owned by one shareholder when it created this 2 year window. However, many S-corporation are owned as community property, or by a husband and wife, or by parents and children, or by multiple unrelated shareholders. So what happens if a surviving spouse or other co-shareholders continue(s) operating the S corporation beyond the 2 year period provided by Congress?
The negligence lies in tax and/or estate professionals’ failure to inform surviving co-shareholders or the deceased person’s family of the need to timely file QSST or ESBT elections. A valid QSST requires the filing of a timely election by each beneficiary, ensuring all trust income is distributed annually to a U.S. citizen or U.S. resident beneficiary. An ESBT, filed by the trustee, is filed for multiple beneficiaries and allows income to accumulate in the trust/estate, but that income is taxed at the highest tax rate (currently 37% federal and 13.3% state (California)). Without proper guidance, these deadlines are missed, “killing” the S corporation’s tax status, and transforming it into a C corporation.
The Resurrection: Why a C Corporation Returns to Life
The term “resurrected” aptly describes the entity’s transformation after an inadvertent termination of the corporation’s S status. As mentioned, S corporations begin as C corporations before electing S status via IRS Form 2553. When the S election terminates, the entity reverts to its prior C corporation status, as if brought back to life in its original, tax-heavy form. This resurrection is not a choice but an automatic consequence under IRC Section 1362(d), imposing the C corporation’s double taxation regime. Corporate income is taxed at 21% (plus 8.84% state (California)), and dividends face shareholder-level taxes up to 23.8% federal and up to 13.3% state (California).
Unless remedial measures can be taken, when the inadvertent termination of S corporation status is discovered by other tax/estate professionals many years later, the trust/estate will be advised that it has to file back tax returns and pay C corporation taxes, potentially eroding a beneficiary’s inheritance by hundreds of thousands of dollars, if not more.
Remedial Measures: Automatic Relief and Late Elections
The IRS provides a lifeline for this “negligent homicide” of an S corporation, offering relief for somewhat late QSST or ESBT elections if:
- Intent: The trustee (ESBT) or beneficiary (QSST) intended the corporation to remain qualified as an S corporation as of the desired effective date (within two months and 16 days of the stock transfer (death)).
- Inadvertence: The failure to make the election was inadvertent, with corrective action taken promptly upon discovery.
- Time Limit: The election is filed within 3 years and 75 days of the desired effective date.
Deciding whether to make a QSST versus a ESBT election is somewhat tricky. The QSST requires that prior S corporation net profits have been actually distributed to the shareholders, and that the corporation will continue to do so in the future so that the trust remains qualified as a QSST. The ESBT election, however, is made when S corporation net profits were accumulated (not distributed) by the trust or estate, or when net profits will be accumulated in the future and distributed in a later year, for example, at the conclusion of the trust administration, or at the conclusion of the probate court case.
Interestingly, while IRS form 2553 is used to make a QSST election (whether timely or late by no longer than 3 years and 75 days), there is no IRS form to make an ESBT election. Instead, the ESBT election must be drafted according to IRS specifications in declaration format and signed under penalty of perjury.
The Last Resort: Private Letter Ruling
When automatic relief is unavailable— because time has lapsed beyond the 3-year-and-75-day period—a Private Letter Ruling (PLR) is required. This process involves IRS user fees of $3,850 to $43,500 (depending on corporate annual revenue) and requires demonstrating that the termination was inadvertent, that the application is not tax-motivated, and that consistent S corporation tax return filings were maintained over the years. Corrective actions, like filing the QSST or ESBT election, must be completed within 120 days of approval. Of course, legal fees can exceed $35,000, making it a costly remedy.
Preventive Measures and Professional Accountability
To prevent this S corporation “murder” and unwanted resurrection, professionals must act diligently:
- Record Keeping: Retain Form 2553, QSST/ESBT elections, trust documents, and shareholder agreements and proof of filing of the election (certified mail receipt or fax receipt).
- Timely Communication: Professionals must notify surviving co-shareholders and families of QSST/ESBT filing deadlines after death.
- Conducting Annual Reviews: Tax professionals should verify compliance with S corporation requirements.
Tax Court cases have highlighted the risk of S corporation status termination from obscure errors, emphasizing vigilance. Negligence can lead to fiduciary duty breaches, exposing trustees/executors/administrators and their professionals to liability for otherwise unnecessary corporate tax liability.
Conclusion
The inadvertent termination of an S corporation election, akin to second-degree murder through reckless neglect, results from professionals’ failure to ensure timely QSST or ESBT elections after a shareholder’s death. The corporation’s “resurrection” as a C corporation—reverting to its original, tax-burdened form—imposes double taxation, devastating a beneficiary’s inheritance. Relief under IRS rules can restore S status if an election is filed within 3 years and 75 days, while a costly private letter ruling process is available as a last resort. Professionals must prioritize proactive communication and compliance to prevent this tax tragedy from occurring.
The post Anatomy of an S Corporation “Murder”: Negligent “Tax Homicide” by Professionals and Its Financial Consequences appeared first on Schneiders & Associates.