Inadvertent Termination

Private Letter Ruling 201042010, 10/22/2010

This was originally published on  PAOO onNovember 5th, 2010.

Years ago The Practical Accountant ran a series of cartoons. There would be two guys sitting on a park bench. One appeared to be a distinguished looking business man and the other was, well to use language that is consistent with the artwork, a bum. The latter is always the speaker. Probably the funniest comment, which most people will get was "Read the notes to the financial statements." The really funny one has the less elegantly dressed gentleman saying "There I was sitting on top of the world, when in a thoughtless moment I inadvertently terminated my S election." Well since then, the world has become a more forgiving place at least as it relates to S elections.

Not having to deal with the possibility of an inadvertent termination is one of the several reasons to prefer an LLC, taxed as a partnership, to the S corporation form. I recently mentioned that those remaining C corporations with appreciated property might want to consider purging earnings and profits. This is because an S corporation that has passive income constituting more than 25% of its gross income and accumulated earnings and profits is subject to a penalty tax and if the condition continues for three years, its S status is terminated.

The other advantage an LLC has is the possibility of dividing profits and losses in just about any way you want, as long as the allocations have substantial economic effect. Ironically, this ends up often making the S corporation look better to some, because its single class of stock rule, makes it simpler. You can have an LLC with a single membership class if you want to. Complexity is optional.

So now we get to PLR 201042010. The Company, as it is called in the PLR, has only one class of stock. All shares have the same rights to distributions. They have a very special form of preferred stock though. The shareholder who controlled the checkbook preferred to make distributions to himself or herself. There is a special method that it is used to determine distributions in situations like that. It is the WIFL method (Whatever I Feel Like). I'm actually speculating here. The ruling just said that distributions were disproportionate.

The Company also had accumulated earnings and profits and excess passive income for three years running. Other than that Mrs. Lincoln, how did you enjoy the play?

Much to my surprise, the IRS has ruled this to be an inadvertent termination. I suppose if you drove blind folded that any crashes you had would be inadvertent too, but I don't recommend it. The shareholders have to amend their individual returns to pick up a deemed dividend for the amount of the earnings and profits. Also they have agreed that on receipt of the ruling they will make payments to bring distributions to shareholders into proportion with ownership. Why the stiffed shareholders are waiting till then is beyond me, but that's the deal.

So if you made your S election without purging and are having lots of passive income, its no big deal. You can clean it up. It is still the wiser course to purge first. Their will be interest on those amended returns and it costs money to get these rulings.