Current developments in S corporations.

• Author: Jamison, Robert W., Jr.

Fourteen sections of the Internal J. Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. Over the last 12 months, significant guidance has been released under these Code sections, including the issuance of proposed and final regulations, several court opinions, and IRS rulings that interpret those provisions. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to guidance under Subchapter S, offers the following updates from this past year, as summarized below by Code section.

Sec. 641(c): Electing small business trust

From its enactment in 1996 until it was amended by the law known as the Tax Cuts and Jobs Act (TCJA), (1) an electing small business trust (ESBT) could not have any potential current beneficiary who was ineligible to hold stock directly. (2) Thus, a nonresident alien could not be a potential current beneficiary. Before the TCJA changed the law, regulations provided that any portion of the trust over which any person held grantor-type powers would not be treated as an ESBT. Instead, the grantor or deemed grantor would be treated as the owner of that portion, and any income from the S corporation attributable to this portion would be taxable to the person holding the power. (3)

The change to Sec. 641(c) from the TCJA--specifically, to allow nonresident aliens as potential current beneficiaries--necessitated two changes to the regulations, which were implemented in T.D. 9868. First, the final regulations remove any language in the text or examples in Regs. Sec. 1.1361-1(m) that explicitly or implicitly prohibit a nonresident alien from potential current beneficiary status. Second, they modify the language in Regs. Sec. 1.641(c)-1 that shifted income to a person holding grantor powers so that it did not apply to nonresident aliens.

Sec. 1361: S corporation defined

Sec. 1361(b) lists several conditions that are necessary for a corporation to be eligible for S corporation status. Among these are a limitation on the number of shareholders at any given time; the limitation of eligible shareholders to individuals, estates, and certain trusts; and the requirement that there may only be one class of stock outstanding.

Sec. 1361(b)(1)(D): Class of stock

An S corporation can have only one class of stock. For this purpose, a corporation is treated as having one class of stock if all outstanding corporate shares of stock confer identical rights of distribution and liquidation proceeds. Differences in voting rights are disregarded. (4) The determination of whether all outstanding shares meet this condition is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (governing provisions). Commercial agreements, such as contractual agreements, leases, and loan agreements, are not governing provisions unless a principal purpose of an agreement is to circumvent the one-class-of-stock requirement.

Other instruments, obligations, or arrangements that are not treated as a second class of stock include many options; certain short-term unwritten advances and proportionately held debt; straight debt; certain buy-sell and redemption agreements; and certain deferred compensation plans. (5) For this purpose, under Regs. Sec. 1.1361-1(b)(4), a deferred compensation plan is not outstanding stock (and therefore cannot be a second class of stock) provided it (1) does not convey the right to vote; (2) is an unfunded and unsecured promise to pay in the future; (3) is issued to an individual who is an employee or independent contractor in connection with services provided to the corporation; and (4) is issued pursuant to a plan with respect to which the employee or independent contractor is not taxed currently on the service income (although certain current payment features are permitted).

Deferred compensation agreement is not a second class of stock

A recent letter ruling illustrates a permitted deferred compensation arrangement that was not deemed to create a second class of stock. In IRS Letter Ruling 201926008, the IRS ruled that two arrangements between an S corporation X, its sole shareholder individual A, and service provider individual B were deferred compensation plans. A, B, and X originally entered into Agreement 1 in which A agreed to sell a percentage of stock to B upon the satisfaction of certain conditions. Before any stock was sold, the agreement was replaced by Agreement 2. This latter agreement generally provided B with payment rights upon the occurrence of certain "liquidation" events, such as the sale by X of a majority of its assets; the lease, exchange, or license of substantially all of X's assets; a merger or consolidation in which the legacy shareholders of A" lost control of X; or an IPO of X stock Agreement 2 also contemplated a possible buyout of B's rights, secured by A's X stock, prior to a liquidation event.

The IRS ruled that both Agreement 1 and Agreement 2 were deferred compensation plans under Regs. Sec. 1.1361-1(b)(4) and were therefore not prohibited second classes of stock.

Sec. 1362: Election; revocation; termination

Sec. 1362 describes the procedures for electing or revoking S corporation status. It also states some rules for terminating S corporation status if the corporation fails to meet one or more of the eligibility requirements of Sec. 1361. Sec. 1362(g) includes a restriction for former S corporations that decide to reelect S corporation status, prohibiting a new election for five tax years unless the IRS consents to a new election. An often-used provision within this section provides relief for corporations that have failed to meet eligibility requirements, either at the time of the S corporation election or after the election took effect.

Sec. 1362(f): Inadvertent defective election

A corporation that filed an election to become an S corporation may find that its election was ineffective, for one of two reasons: either (1) it was ineligible to be an S corporation when it filed the election, or (2) the information in the Form 2553, Election by a Small Business Corporation, was incorrect, not all shareholders consented to the election, or the form was filed late. The following discussion addresses several recent letter rulings on these issues.

Multiple classes of stock

IRS Letter Ruling 201935010 addressed an inadvertent defective election from multiple classes of stock. A corporation filed an S election and had filed S corporation returns. Assuming that the election was valid, all of the shareholders filed their individual income tax returns including their pro rata shares of S corporation items. In a later due-diligence study, a potential purchaser discovered that the corporation had two classes of stock when the corporation filed its S election. One class was voting stock, and the other was nonvoting. Although Subchapter S allows a difference in voting rights, each shareholder must nonetheless have equal distribution and liquidation rights. However, the directors of this corporation had amended the liquidation rights, causing the corporation to be in violation of the single-class-of-stock requirement. After discovering the problem, the corporation amended its articles of incorporation so that both classes of stock had equal liquidation rights. The IRS ruled that the invalidity of the election was inadvertent and that the corporation had been an S corporation since the effective date of the election.

IRS Letter Ruling 201949009 concerned a limited liability company (LLC) that had filed an election to be an S corporation. The operating agreement stated that the company was to be a partnership for federal income tax purposes and the members were to be treated as partners. In addition, there were two classes of ownership interests--a capital interest and a profits interest. Upon liquidation of the partnership, the profits interest could only receive the assets attributable to income after the issuance of the profits interests. Since the capital and profits interests were not entitled to equal amounts pro rata, the company had violated the single-class-of-stock rule. The entity in question merged into another corporation in a Type F reorganization, in which there is a mere change in identity, form, or place of organization of one corporation before the merger. The surviving corporation represented that all of the entity and owner returns from the initial date of the S election were filed consistently as if an S election had been in effect. The IRS treated the merged entity as if the S election had been in effect from the initial date of the election until the merger. It declined to rule on whether...