IRS Issued Simplified Procedures to Resolve Common S Corporation and QSub Errors
November 14, 2022
By: Marc T. Finer
Failure to meet and maintain the requirements to be treated as an S corporation for federal income tax purposes can result in the loss of S corporation status and the resulting loss of pass-through entity tax treatment.
Defects in a corporation’s S corporation status are often raised during the acquisition due diligence process and sometimes require the costly and time-consuming filing of a request for a private letter ruling (“PLR”) to correct.
On October 11, 2022, the IRS issued Revenue Procedure 2022-19 (the “Revenue Procedure”) to provide taxpayers with a process for resolving common S corporation and qualified subchapter S subsidiary (“QSub”) issues without the need to request a PLR to obtain certainty of S corporation status. LLCs that are treated as S corporations for federal income tax purposes may also qualify for this liberalized relief.
The Revenue Procedure identifies the following six common issues that are eligible for corrective relief under the Revenue Procedure without the need for a PLR:
- Agreements and arrangements with no principal purpose to circumvent the one-class-of-stock rule. The IRS will not treat an S corporation as violating the one-class-of-stock rule because of certain agreements or arrangements so long as the agreements and arrangements (i) are not considered governing provisions (e.g., articles of incorporation, bylaws, binding agreements that relate to distributions and liquidation proceeds) and (ii) a principal purpose of the agreements and arrangements is not to circumvent the one-class-of-stock rule. This latter requirement applies to commercial contracts such as contractual agreements, leases, buy-sell agreements, redemption agreements and debt agreements.
- Disproportionate distributions. The IRS will not treat disproportionate distributions as violating the one-class-of-stock rule as long as the corporation’s governing documents (e.g., certificate of incorporation, bylaws and binding agreements that relate to distribution and liquidation proceeds) provide for identical distribution and liquidation rights.
- Inadvertent errors or omissions on IRS Form 2553 (Election by a Small Business Corporation) or IRS Form 8869 (Qualified Subchapter S Subsidiary Election). An S corporation or QSub election will not be invalidated based on an error or omission on IRS Form 2553 or IRS Form 8869 other than certain errors and omissions relating to a shareholder consent, selection of a permitted tax year or an officer’s signature.
- Lack of a written acknowledgment that the IRS has accepted a corporation’s S corporation or QSub election. The lack of written acknowledgment from the IRS does not result in the termination of an S corporation or QSub election.
- Filing a federal income tax return that is inconsistent with an S corporation or QSub election (e.g., IRS Form 1065 (U.S. Return of Partnership Income)). Failure to file the appropriate tax return does not affect the validity of an S corporation or QSub election.
- Correcting non-identical governing provisions. If an S corporation election is invalid or terminated solely due to non-identical governing provisions (such as provisions in an operating agreement for an LLC that has made an S election which provide that distributions are required to be made in accordance with positive capital accounts rather than in accordance with percentage interests), the S corporation will be treated as continuing provided all of the following requirements are satisfied:
- The corporation has or had one or more non-identical governing provisions;
- The corporation has not made and is not deemed to have made a disproportionate distribution to a current or former shareholder;
- The corporation has filed an IRS Form 1120-S (U.S. Income Tax Return for an S Corporation) for each applicable year; and
- The corporation satisfies the other requirements of the Revenue Procedure before the IRS discovers the non-identical provisions.
- In addition, the Revenue Procedure identifies certain matters for which the IRS will no longer issue a PLR, including whether a principal purpose exists for purposes of the one-class-of-stock rule and any issue which is addressed by the Revenue Procedure. The Revenue Procedure is generally effective October 11, 2022.
One of the reasons stated for the issuance of the Revenue Procedure is to reduce costs and delays for completing transactions involving S corporations and QSubs. This is particularly applicable in the M&A context where an invalid S corporation election can cause the buyer to become liable for the target’s unpaid corporate-level taxes as the owner of the target stock or transferee of the target’s assets.
In addition, an invalid S corporation election may prevent the buyer from obtaining a basis step-up in the target’s assets pursuant to certain tax elections which are predicated on the target being a valid S corporation.
Questions regarding the validity of an S corporation election can result in closing delays, additional escrow requirements, holdbacks, expanded indemnity provisions and/or a restructuring of the transaction. Revenue Procedure 2022-19 provides an opportunity for parties involved in the acquisition of an S corporation to resolve certain S corporation issues more quickly, efficiently and economically than previously allowed, without the need to obtain a PLR.