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Overlooked Election: The IRS Shows Mercy

Imagine this: John Smith decides to fulfill his life’s dream. He retires to open a restaurant in the heart of Manhattan’s theater district. John hires a lawyer to draft the documents to establish the business as an S corporation to take advantage of favorable tax treatment. As with most new businesses, John’s restaurant takes awhile to catch on. The restaurant suffers a $300,000 taxable loss in its first year. As the lone shareholder in the S corporation, John is allowed to recognize this loss on his personal income tax return, eliminating nearly all of his tax liability.

But wait: John receives a notice from the Internal Revenue Service indicating that the appropriate S corporation election was never filed. It turns out that his lawyer wasn’t as good as John thought he was. Not only has John lost the favorable tax treatment for S corporations, but he also now owes taxes, interest and penalties because he cannot claim the $300,000 loss reported on his personal income tax return. John’s situation may seem bleak, but it’s not hopeless. The IRS allows taxpayers to request relief in such situations, providing an extension of time to file the election. This is known as Section 9100 relief.

Section 301.9100 of the IRS income tax regulations provides for two types of relief. The first is for elections that qualify for an automatic six- or 12-month extension, which falls under §301.9100-2. The IRS grants an automatic sixmonth extension for all regulatory elections, excluding elections eligible for the 12-month automatic extension. These include the election to use a last-in-first-out (LIFO) inventory method and other less prominent regulatory elections. To take advantage of the six- or 12-month automatic extension, a taxpayer can file an amended return within the extension period.

Taxpayers for whom the automatic extension periods have expired may still request relief under §301.9100-3. To qualify under this section, the taxpayer must provide evidence that he or she acted reasonably and in good faith (i.e., the taxpayer always conducted himself or herself as though he or she made a timely election) and that the granting of relief will not “prejudice the interests of the government.” Examples of this are if the taxpayer would have a lower tax liability by filing the election late than if the election had been timely filed, or if the statute of limitations, typically three years, has already lapsed for the tax year in question.

Generally, a taxpayer will be considered to have acted reasonably and in good faith in these cases:

  • If the taxpayer requests relief under §301.9100-3 before the IRS discovers the failure to make the election;
  • If the taxpayer failed to make the election as a result of events beyond the taxpayer’s control;
  • If, after reasonable diligence, the taxpayer was unaware of the necessity to make the election (taking into account the taxpayer’s experience and the complexity of the issue at hand);
  • If the taxpayer reasonably relied on written advice from the IRS;
  • If the taxpayer reasonably relied on a tax professional, such as an accountant or lawyer, and the professional failed to make, or advise the taxpayer to make, the election.

Requesting 9100 relief for elections past the automatic extension periods requires the taxpayer to seek a private letter ruling from the IRS. Aprivate letter ruling is a statement issued by the IRS that applies the tax laws to a taxpayer’s specific set of facts. Private letter ruling requests are often very complicated. In its simplest form, a private letter ruling request will include a statement of facts describing the situation, the ruling the taxpayer is requesting, a statement and analysis of the laws relating to the issue, and numerous procedural matters required for IRS processing.

The request can be costly. IRS filing fees range from $500 to $6,000, depending on which regulatory election is in dispute, the type of response requested from the IRS, and the gross income of the taxpayer making the request. This does not include any fees paid to a tax professional for drafting the request, which also will vary depending on the complexity of the ruling needed.

Because of the high cost of a private letter ruling, taxpayers must assess the amount at risk and determine whether the cost is worthwhile. In our example, John Smith has the $300,000 of loss reported on his tax return, as well as interest and penalties on the underpaid tax. In this case, submitting a private letter ruling request probably makes sense. In addition, a taxpayer must also assess the strength of his or her case for a favorable ruling. It does not make much sense to spend a significant amount of time and money to seek a private letter ruling when there is little chance of having the request granted. In any case, taxpayers considering private letter rulings should consult their tax advisors before acting.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.