Diligence will test whether your S election is valid

Buyer tax diligence traces your S election back to the day it was made. If that election was never valid, or terminated years ago without anyone noticing, the company has been a C corporation the whole time. Corporate-level tax, interest and penalties follow that fact into your deal. So does a repriced, restructured transaction.

Why does buyer tax diligence go back to the day the S election was made?

Buyer tax diligence goes back to formation because S status is one election, not a choice made fresh each year. It was either valid and stayed valid, or it was not. A single disqualifying fact, on a single day, terminates it, and every year after is a C corporation year.

The rule is narrow. An S corporation must be a domestic corporation that is not an ineligible corporation, with no more than 100 shareholders, no shareholder other than an individual, an estate, a qualifying trust or certain exempt organizations, no nonresident alien shareholder, and one class of stock.

The consequence is arithmetic. As of September 2026 the federal corporate income tax rate is 21 percent of taxable income, and a company that believed it was an S corporation paid none of it. If the election was invalid, that tax was owed all along, with interest and penalties on top.

Do not assume the three-year assessment period solved this quietly. A filed Form 1120-S generally starts the clock, though the IRS has argued that a return reporting no corporate tax does not always start it. Where no return was filed, tax may be assessed at any time.

Law: 26 U.S.C. 1361(b)(1), (c)(2), (c)(6); 1362(d)(2); 11(b); 6037(a); 6501(a), (c)(3); 6601; 6651. Treas. Reg. 1.6037-1(c).

What does an invalid S election do to the structure of the sale?

An invalid S election removes the elections that let a buyer purchase stock and still take a stepped-up basis in the assets. A section 338(h)(10) election requires a target that is an S corporation or a member of an affiliated group. A section 336(e) election requires an S corporation target or a corporate seller. Neither survives.

Read the section 338(h)(10) conditions before assuming that one is available. The purchaser must itself be a corporation making a qualified stock purchase of at least 80 percent of the stock by vote and value; an individual or an LLC cannot. It is made jointly on Form 8023, and every shareholder consents, including a non-seller.

That condition bites when the buyer is an individual, an LLC or a fund. For those buyers the step-up comes through a section 336(e) election, which for an S corporation target requires every seller to be an eligible shareholder, or through an F reorganization under Rev. Rul. 2008-18. Both need S status.

Without it, the buyer takes stock at carryover basis and pays less, buys assets and absorbs two levels of tax, or walks.

The buyer is not paying for your understanding of the election. The buyer is paying for the paper that proves it.

Law: 26 U.S.C. 338(d)(3), (h)(10); 336(e). Treas. Reg. 1.338-3(b)(3); 1.338(h)(10)-1(c); 1.336-1. Rev. Rul. 2008-18.

Which S election defects actually turn up in diligence?

Five defects account for most S election failures found in diligence: non-identical governing provisions in an operating or shareholder agreement, an ineligible shareholder, a trust holding stock without the election it needed, a Form 2553 nobody can produce, and a subsidiary for which no qualified subchapter S subsidiary election was made.

I read the Form 2553 and the shareholder consents before the stock ledger, and the distribution history before the operating agreement.

Can your operating agreement create a second class of stock?

A second class of stock is created when the governing provisions do not give every outstanding share identical rights to distribution and liquidation proceeds. Governing provisions include the charter, the bylaws, applicable state law and any binding agreement relating to those proceeds. An LLC operating agreement or a shareholder agreement is squarely inside that definition.

This is where an LLC taxed as an S corporation gets into trouble. The operating agreement came off a partnership template, carrying a preferred return, a liquidation waterfall keyed to capital accounts, or a tax-distribution clause keyed to each member’s own rate. The regulation does not ask about intention.

Two limits help. Ordinary commercial arrangements such as leases and loans are not governing provisions unless a principal purpose is to circumvent the requirement. And where state law makes the company pay or withhold tax for particular shareholders, that payment is disregarded provided the constructive distributions, once counted, come out pro rata.

Law: Treas. Reg. 1.1361-1(l)(1), (l)(2)(i) and (l)(2)(ii).

Which shareholders and trusts break an S election?

An S corporation may not have a nonresident alien, a corporation or a partnership as a shareholder. Trusts qualify only in defined categories. Grantor trusts, voting trusts and testamentary trusts qualify without an election, some only for a limited period. A qualified subchapter S trust or an electing small business trust qualifies only if its election is filed.

Timing is where these fail, and the triggers are ordinary events: an estate plan funded, a death, a divorce settlement. A QSST election is generally due within the 16-day-and-2-month period beginning on the day the stock is transferred to the trust, and an ESBT election follows a parallel period under its own rule. Where the deemed owner of a grantor trust dies, the trust has two years, and the election falls due within the same period afterwards. If the trust fits no permitted category, the election terminates the day it takes the shares.

Residency is narrower than it sounds. A United States citizen who moves abroad stays a citizen and stays eligible. The risk sits with a shareholder who is not a citizen: a green card surrendered, or a resident who fails the substantial presence test, becomes a nonresident alien and ends the election that day.

Law: 26 U.S.C. 1361(b)(1)(B), (C); 1361(c)(2); 1361(d), (e). Treas. Reg. 1.1361-1(g), (h), (j)(6)(iii), (m)(2).

Nobody can find the Form 2553. Is the election still valid?

A missing IRS acceptance notice is not a missing election. The notice, CP261 for an S election, acknowledges acceptance and does not affect validity, and a replacement can be requested from the IRS. A missing Form 2553 is a different problem, because the election is made on that form.

Rev. Proc. 2022-19 addresses errors and omissions on a Form 2553 that was filed, and confirms that the acceptance letter is administrative, with no ruling issued for its absence. It says nothing about a form that cannot be produced at all.

If the form was never filed, late election relief may still be available. Rev. Proc. 2013-30 covers late S, ESBT, QSST, QSub and entity classification elections where the entity intended the election, has reasonable cause and filed consistently. Relief is generally requested within three years and 75 days of the intended effective date. For a late S election only, the procedure reaches past that period where the corporation and its shareholders reported consistently. No equivalent extension exists for a QSST, ESBT or QSub.

What if a subsidiary never had a QSub election?

A missing qualified subchapter S subsidiary election does not by itself invalidate the parent’s S election. Since the Small Business Job Protection Act of 1996, an S corporation may own 80 percent or more of a C corporation. The missing election leaves the subsidiary a separate corporation with its own returns, its own tax and its own exposure.

The election is made on Form 8869 and acknowledged on CP279 and CP279A. A QSub is not a separate corporation; its tax items are the parent’s.

There is a sharper trap. If the subsidiary had its own S election before you acquired it, that election terminated on acquisition, because a corporation is not a permitted shareholder. Unless a QSub election was made effective as of the acquisition date, the subsidiary has been a C corporation ever since.

Law: 26 U.S.C. 1361(b)(3); Treas. Reg. 1.1361-4. Rev. Proc. 2013-30; Rev. Proc. 2022-19.

Does Rev. Proc. 2022-19 fix this without a private letter ruling?

Rev. Proc. 2022-19, issued October 11, 2022, lets many S election problems be corrected without a private letter ruling. It reaches six areas: non-identical governing provisions, principal-purpose determinations under the one class of stock rule, disproportionate distributions, inadvertent errors on Form 2553 or Form 8869, missing acceptance letters, and inconsistent return filings.

The relief for non-identical provisions has conditions, and each is a gate. No disproportionate distribution made or deemed made to an applicable shareholder. Form 1120-S timely filed for each applicable year. The required statements completed before the IRS discovers the defect.

Read that last condition carefully. Non-identical provisions alone are self-correctable. Those provisions plus a disproportionate distribution are not, and the window shuts the moment the IRS finds the defect first.

What happens if the defect falls outside the revenue procedures?

Section 1362(f) is the statutory backstop, and it runs through a private letter ruling. The IRS may treat an invalid or terminated election as valid where the failure was inadvertent, corrective steps were taken within a reasonable period after discovery, and the corporation and every affected shareholder make the required adjustments.

The relief is discretionary, not automatic, and the calendar is the problem. A ruling request is prepared, filed with the required user fee, and waits in the national office, commonly for months. A 90-day exclusivity period does not.

If the election did terminate, re-electing is not a same-day fix. The corporation, and any successor, generally cannot elect again before its fifth taxable year beginning after the first year for which the termination was effective, unless the IRS consents.

Law: 26 U.S.C. 1362(f); 1362(g).

Why is the S corporation representation the most negotiated sentence in the purchase agreement?

The S corporation representation is the sentence in which you personally warrant that the company has been a valid S corporation since a stated date. Buyers negotiate it apart from the general representations because the exposure is computable, and because an unresolved defect gets paid out of your proceeds.

Understand the mechanics before you sign. Where the agreement caps general representations and applies a basket, expect the buyer to ask that this one sit outside the cap, survive longer, and be secured by whatever the deal already uses: a holdback, part of the escrow, or setoff against a seller note. A separate escrow funded for this representation alone is a larger-deal habit, worth resisting where a deal carries one security mechanism rather than several. Insurance excludes known issues, so it is no answer.

What the buyer prices is entity-level tax on every open year, plus interest, penalties, and the step-up it no longer gets. Fixing the defect first keeps the indemnity, the holdback and the asset-deal restructure out of the negotiation.

What should you do before you go to market?

Rebuild the S election file before a buyer asks for it, because diligence is a bad time to learn a form is missing. The file has a fixed contents list, and every item either exists or does not. Assemble it, read the gaps, and close them while you control the timeline.

• The signed Form 2553, with consents from every shareholder at the effective date.
• The CP261 acceptance notice, or a replacement request.
• Every stock transfer since the election, with eligibility proof for each new holder.
• Each trust instrument holding shares, with its election and acknowledgment.
• Form 8869 for every corporate subsidiary, with CP279 and CP279A.
• The operating, shareholder and buy-sell agreements, read for distribution terms.
• The distribution history, year by year, against ownership percentages.
• Every Form 1120-S since the effective date, with matching Schedules K-1.

Then rank what you find. A gap that Rev. Proc. 2022-19 or Rev. Proc. 2013-30 can close is a document exercise. A gap needing a section 1362(f) ruling is a decision to take before a letter of intent sets a date the ruling cannot beat.

Ask the same questions at the state level, in writing; state conformity is not uniform. The federal tax position here is stated as of September 2026. Confirm currency before relying on it in a live deal.