Current developments in S corporations.

• Author: Brajcich, Andrew M.

Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. (1) Over the 12-month period ending March 2023 covered by this article, several of these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section (starting with those in Subchapter S and then other sections) and often contain a short description of the relevant provision.

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) restricts S corporations for which the S election has been terminated from reelecting S corporation status before the fifth tax year after the year of termination, 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.

Certain relief under Sec. 1362 requires a taxpayer to submit a request for a private letter ruling. User fees for these letter rulings are updated annually. The user fees prescribed by Rev. Proc. 2023-1 for a private letter ruling request submitted after Feb. 2, 2023, were unchanged from those of the previous annual period. (2) However, taxpayers considering requesting a letter ruling for an inadvertent S election termination should review Rev. Proc. 2022-19 for potential relief.

Rev. Proc. 2022-19 adds new relief rules for S corporations: In October 2022, the IRS issued Rev. Proc. 2022-19, dealing with frequently encountered issues concerning the validity of S corporations. Historically, private letter rulings, which are costly for taxpayers and administratively burdensome on the IRS, have often been used to seek relief for noncompliance with S corporation requirements. Rev. Proc. 2022-19 attempts to provide taxpayers with certainty in six areas without having to use private letter rulings. (3) These areas include common issues regarding the one-class-of-stock rule and procedural corrections for certain inadvertent errors or omissions.

Sec. 1361(b)(1)(D) provides that an S corporation may not have more than one class of stock issued. For purposes of determining whether more than one class of stock has been issued, voting rights are disregarded. (4) Distribution and liquidation rights, however, must be uniform across all shares. (5)

Under Rev. Proc. 2022-19, the IRS will not terminate a corporation's S status for violating the single-class-of-stock requirement through rights arising in certain agreements or arrangements, so long as there is no principal purpose to circumvent the single-class requirement. (6) The taxpayer's principal purpose is a question of fact. As such, Rev. Proc. 2022-19 states that the IRS will not provide a ruling on a taxpayer's principal purpose, (7) potentially leaving taxpayers with uncertainty and the inability to seek some level of assurance through the ruling process.

Additionally, Rev. Proc. 2022-19 provides that the IRS will not treat any disproportionate distributions as violating the one-class-of-stock requirement when the governing provisions of the corporation provide for identical distribution and liquidation rights. (8) This position is consistent with the Tax Court's decision in Mowry, (9) where unauthorized disproportionate distributions to a majority shareholder did not invalidate the S corporation election. In that case, the IRS was in the unusual position of arguing for maintaining S status in what seems to have been an effort by the government to stay out of a shareholder dispute. The question raised by this position in Rev. Proc. 2022-19 is, at what point, if any, are the distributions too disproportionate to continue to maintain S status? The AICPA asked that question in a recent comment letter to Treasury and the IRS. (10)

If a governing instrument is inconsistent with the single-class-of-stock rule, referred to as "non-identical governing provisions" in Rev. Proc. 2022-19, the situation is more complicated. (11) A common example of this scenario is a limited liability company (LLC) or limited partnership operating agreement containing partnership tax provisions. Such provisions may appear as boilerplate language in agreements drafted by the uninformed or found online. The IRS has previously ruled that these provisions invalidated or terminated S corporation status; however, the entity could seek to retain its S status under the inadvertent-termination-relief rules of Sec. 1362(f). (12)

When a corporation has a nonidentical governing provision, Rev. Proc. 2022-19 offers retroactive relief if the corporation meets three conditions:

* Since the corporation adopted the provision (or elected S status if the provision was already in effect), it has made no disproportionate distributions;

* The corporation has consistently filed Form 1120-S, U.S. Income Tax Return for an S Corporation, within six months after its original due dates (excluding extensions); and

* The IRS has not yet discovered the nonidentical provision. (13)

Unlike under earlier revenue procedures dealing with late elections, (14) inadvertent invalid elections, and inadvertent terminations, an S corporation with a nonidentical governing provision may correct this default without filing any request with an IRS Service Center or the National Office. The corporation prepares a statement, signed by a corporate officer, that details the nonidentical governing provision and states the corrective action. It describes the new identical governing provision. It includes a list of all persons who have been shareholders since the nonidentical governing provision took effect until the corporation adopted the new identical governing provision. Each shareholder must attach a statement, signed under penalties of perjury. The corporation retains this documentation in its permanent records. (15)

When disproportionate distributions occur in conjunction with nonidentical governing provisions, it appears the corporation is not eligible for the retroactive relief provided in Rev. Proc. 2022-19. In its comment letter, the AICPA recommended that Treasury and the IRS amend Rev. Proc. 2022-19 to provide for retroactive relief when disproportionate distributions are inadvertent.

Also in Rev. Proc. 2022-19, the IRS updated some of its no-rule areas. First, the IRS will not issue "comfort rulings" for any S corporation problem if Rev. Proc. 2022-19 or another pronouncement, such as Rev. Proc. 2013-30, offers relief. Moreover, as mentioned above, it will not rule on the principal purpose of any governing instrument. (16) Therefore, S corporations with nonidentical governing provisions that do not qualify for relief under Rev. Proc. 2022-19 will need to represent that the governing provision in question did not have avoidance of the single-class-of-stock rule as a principal purpose.

Rev. Proc. 2022-19 also outlines procedures on how to address missing shareholder consents, permissible-year errors, missing officer signatures, and other inadvertent errors and omissions, as well as procedures for verifying S or qualified Subchapter S subsidiary (QSub) elections and return filing.

Recent IRS letter rulings provide relief from Sec. 336 late elections: In recent months, the IRS has issued an increasing number of private letter rulings providing relief from late elections under Sec. 336(e). Although the letter rulings (17) do not directly address the reason for the late election, presumably, relief has been necessary in these situations because the target corporation failed to timely file its final tax return for the period ending on the date of sale.

When a taxpayer acquires the stock of a target corporation in a transaction meeting the definition of a "qualified stock purchase" in Sec. 338(d) or a "qualified stock disposition" in Sec. 336(e), the parties may agree to elect to treat the transaction as an asset acquisition for tax purposes, resulting in a stepped-up basis in the acquired assets.

Under Sec. 338(h)(10), the election may only be made when a corporate acquirer purchases the stock of certain types of targets. One such permitted target is an S corporation, and when a purchasing corporation (Purchasing Corporation) acquires the stock of an S corporation (Old Target) in a qualified stock purchase and Purchasing Corporation and the Old Target shareholders make a joint Sec. 338(h)(10) election, the election results in a fictional transaction for tax purposes. (18)

First, Old Target is treated as if it sold its assets to a corporation newly formed by the acquiring corporation (New Target) in exchange for the proceeds of the stock sale plus any liabilities of Old Target deemed assumed by New Target. Then, Old Target is deemed to transfer the proceeds from the stock sale to its shareholders in complete liquidation. The sale of stock by Old Target's shareholders to Purchasing Corporation is disregarded, and Old Target's S election continues through the end of the acquisition date.

Alternatively, Sec. 336(e) allows an election that results in the same consequences as previously described; as opposed to Sec. 338, however, the Sec. 336(e) election may also be made when the acquirer is not a corporation.

If Old Target is an S corporation, there is often confusion over the due date for its final tax return upon making an election under either Sec. 338(h)(10) or Sec. 336(e). A missed...