Invalid S Corp

[Snaggletooth]

My client is a C-corp who invested $10,000 in another corporation [Corporation X}. Both corporations are typical commercial corporations, neither being a §401 or §501 or anything squirrely. Investment occurred in 2002, and there have been no dividends declared during this period.

In 2008 Corporation X decides it wants to convert to a subchapter S. My client knew nothing about it until they received a K-1 Form 1120S. Of course, the existence of a corporate shareholder in Corporation X means that its status as a Sub S is invalid.

What is my responsibility as a tax preparer? Should I decline to file on the K-1 income because I know it is improper? Should I contact Corporation X? Should I ask my client to contact Corporation X?

I am certain it is not my job to police the validity of Corporation X status. But should someone notify them?

[erchess]

My Two Cents

I see this as like any other situation in which you discover a client's tax problem. You tell your your client as much as you can about the nature of the problem and the consequences of various courses of action. Under no circumstances do you yourself disclose anything to anyone but this person without duly documented permission. Then you let your client make the decisions: what if anything to tell who if anyone else about the invalid S Election; and how to report the income from Corp X.

I think if your client is not a fool he or she will tell all the other owners of Corp X about the problem and possibly arrange for a change in personnel responsible for its tax affairs. (I don't know if you ethically can or would want to offer to become its paid preparer.) I think your client should instruct you to determine as nearly as possible the correct character of the items from the K1 and report them as though they had been reported appropriately with proper disclosures or else file for extension until the situation clarifies. I am sure the IRS will grant as much time as necessary. You obviously have to prepare the return you prepare correctly or not at all. I personally would disengage from a client who cannot see the need to raise the alarm with the other owners of Corp X but I don't think there is any rule enforcing the latter if for some reason you continue to want or need the business.

[erchess]

Possible Solution?

Are all the owners of the corporation for which you prepare the return eligible shareholders of an S Corp? Would it be ethical and legal simply to transfer ownership of Corp X to personal ownership by the owner or owners of the corporation whose return you prepare? If it is possible would it make everyone happy?

What bothers me is that I question whether it is legal for a corporation to do this kind of thing retroactively. I am absolutely sure that if everyone was agreeable ownership in Corp X could have been transferred to the owner or owners of the corp whose return you prepare and then if they are all eligible S Shareholders Corp X could have become an S Corp. If some are not eligible S Shareholders other value could have been transferred to them. As long as all the owners were happy and decisions were made prior to their taking effect I am sure there would have been no problems.

The root of the problem is that Corp X made a badly flawed decision and I would question the competence of its tax adviser.

[xgflek]

Who gave shareholder consent on Form 2553?

Just out of curiosity, who signed the Form 2553 giving shareholder consent for the S-corp election for your C-Corp's ownership interest in Corp X?

[Snaggletoof]

Xgflek hits it - BINGO!

Now we're getting somewhere! Xgflek, these are my sentiments exactly. According to the owner of the C Corp, no one ever asked him about converting to an S corp. Clearly, poor handling somewhere along the line.

Of course, Corporation X has not engaged me to do any work and it is obvious that even if they did, it would run afoul of what their tax accountant is doing. I'm just wondering what my responsibilities are, ethically, and what they might be under Cir 1230.

Thanks for responding Xgflek. I have some vowels for sale if you want any...

Consonants too. I swapped them out with the composer of "Old McDonald Had a Farm." He was going bonkers with eeieyeeeieyeyoo.

[Roland Slugg]

What ethical concerns?

Dear Snag

I see no ethical concerns or confidentially issues here at all. I would let my client know that the S Corp election (if there ever was one) is invalid, and the K-1 income should not be reported on the C Corp's return. I would then ask my client for permission to contact X Corp's tax preparer, if you can locate him, or else someone at X Corp itself. If handled correctly, you might even gain a new client ... X Corp ... if its owner(s) realizes his current advisor is lacking important basic knowledge.

[Snaggletoof]

Great to have you Back

Sluggo, been awhile since we've heard from you. We miss your incisive analysis and broad-based tax knowledge. Don't stay away so long!!

[BHoffman]

Snags - agree with Roland. Also, was the K-1 issued to the shareholder personally or to his corporation?

In any event, this is an error that needs to be corrected somehow or your client could be in for a messy time.