On December 1, 2021, the Tax Court issued a Memorandum Opinion in the case of Chan v. Commissioner (T.C. Memo. 2021-136). The primary issue presented in Chan was whether the entity in question (which filed a Form 2553, Election by a Small Business Corporation, by which it elected to be treated as an S corporation) was an S corporation or a C corporation.
Background to Chan v. Commissioner
The petitioners operated a restaurant in California by the name of Younique Café Inc. (“YCI”). The restaurant was incorporated in 2010. The petitioner-husband filed articles of incorporation for YCI in August 2010 and subsequently decided to convert it to an S corporation. In March 2011, he filed on YCI’s behalf a Form 2553, electing that the restaurant be treated as an S corporation for Federal income tax purposes. He signed the form as the president of YCI and requested that the conversion be effective January 1, 2011.
The Form 2553 was sent to the IRS by certified mail, and it was stamped “received” by the IRS Ogden Service Center on March 11, 2011. It was stamped “received” by the IRS “entity department” three days later – likely by Felicia, as she is rather fond of stamping things. In October 2016, the petitioners timely filed a joint Federal income tax return for 2015, reporting wages of $47,500 and a total tax liability of $2,800. They did not report any income or expenses attributable to YCI. The petitioners filed no return for 2016. YCI ceased operations in 2017.
In 2019 the IRS initiated an examination of the petitioners’ 2015 and 2016 tax years. The RA found no evidence that YCI had ever filed a corporate income tax return of any sort, even though YCI had made a valid election to be treated as an S corporation.
In September 2019, the IRS issued the petitioners a notice of deficiency for 2015, determining a deficiency of $408,312 and an accuracy-related penalty of $81,662. The notice determined that YCI for 2015 had gross receipts of just north of $1.1 million and that the petitioner-husband had ordinary income from a trade or business in the same amount.
Because the petitioners failed to file a return for 2016, the IRS prepared for them separate substitutes for returns. The SFR for petitioner husband determined that YCI for 2016 had “gross receipts or sales” of $731,444, and income in the same amount.
Proceeding pro se, the petitioners did not dispute that YCI had gross revenues of $1,139,879 for 2015 and $731,444 for 2016. Instead, they asserted that YCI was a C corporation and that its revenues had “nothing to do with 1040 Form personal income.”
The C Corporation “Returns”
The petitioners contend that YCI was a C corporation at all relevant times, and in support of this argument, the petitioners provided copies of Forms 1120, U.S. Corporation Income Tax Return, prepared on YCI’s behalf for fiscal years ending July 31, 2016 and 2017. The first document shows gross revenues of $1,110,432 and a loss of $20,742; the second document shows gross revenues of $701,790 and a loss of $38,563.
Both forms indicate preparation by a professional return preparer, but neither shows a preparer signature or date. Both returns are signed by petitioner husband as president of YCI, but neither signature bears a date. Petitioners have supplied no evidence (such as a certified mail receipt) to show that these documents were “actually” filed with the IRS.
The Crux of the Issue
The IRS’ determinations in a notice of deficiency are generally presumed correct, and taxpayers bear the burden of proving them erroneous. Petitioners contend that they are liable for no deficiencies because YCI was a C corporation, not an S corporation, during 2015 and 2016.
An S corporation is a small business corporation for which an election under IRC § 1362(a) has been made. S corporations are afforded special treatment under the Code. One of the benefits of S corporation tax status is that income earned by the entity escapes corporate-level taxation. Thus, an S corporation’s income passes through the entity and is, generally, taxed only at the shareholder level on a pro rata basis.
IRC § 1362 specifies the procedure for electing S corporation status. If an entity qualifies as a “small business corporation” (petitioners do not dispute that YCI so qualified), it may make an election “on or before the 15th day of the 3rd month of the taxable year.” To make an election the entity must file “a completed Form 2553.” Notably, the petitioners do not dispute that petitioner husband timely filed “a completed Form 2553” in 2011, that this form was received by the IRS, or that YCI’s election complied with all applicable requirements.
Once an entity elects S corporation status, the election is effective “for all succeeding taxable years.” The election will be terminated if and only if (1) the shareholders make an affirmative revocation, (2) the entity ceases to be a “small business corporation,” or (3) the entity’s passive investment income exceeds 25% of its total gross receipts for the previous three years.
The petitioners do not allege that any terminating event occurred during 2015 or 2016 (or previously). Thus, the Tax Court states (not mincing words), “they have no basis to dispute that YCI was an S corporation during 2015 and 2016.”
In their response to the motion for summary judgment, the petitioners argue that YCI must have been a C corporation because it allegedly filed Forms 1120 for 2015 and 2016.
The Tax Court disagreed.
First, the IRS has no record of YCI’s having filed any type of tax return for these years. The Forms 1120 attached to petitioners’ responses are not signed or dated by the alleged return preparer, and petitioners have submitted no evidence (such as a certified mail receipt) to show that these documents were “actually” filed with the IRS. In any event the filing of a Form 1120 on behalf of an entity is not a “revocation statement” and it does not, therefore, terminate a valid election by the entity to be treated as an S corporation.
- As authorized by IRC § 6020(b). ↑
- See Tax Court Rule 142(a). ↑
- IRC § 1361(a)(1). ↑
- Mourad v. Commissioner, 121 T.C. 1, 3 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004). ↑
- Id.; see IRC § 1363; IRC § 1366. ↑
- IRC § 1362(b)(1)(B). ↑
- Treas. Reg. § 1.1362-6(a)(2)(i). ↑
- IRC § 1362(c); see Mourad, 121 T.C. at 4 (observing that an election to be an S corporation continues until terminated). ↑
- See IRC § 1362(d). ↑
- See Treas. Reg. § 1.1362-6(a)(3)(i) (an entity may revoke its election by filing a revocation statement). ↑
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