This article was written by Ali Hassan, Staff Accountant.
Simplified revenue procedures allow S corporations and QSubs to address common S status violations without obtaining costly IRS Private Letter Rulings
In Revenue Procedure 2022-19 (Rev Proc) the IRS authorizes and provides guidance for S Corporations and their shareholders to resolve frequently encountered S corporation status termination issues without obtaining a private letter ruling (PLR) from the IRS. Previously, S corporations which inadvertently fell short of the requirements necessary to secure or retain S corporation status were required to obtain a favorable PLR to validate or continue their S corporation status. Obtaining a PLR for this purpose required an IRS User Fee of $38,000, plus substantial professional fees. In addition, S corporations were required to file the PLR with the IRS Office of Chief Counsel, which often took several months to complete.
The self-cure opportunities provided by the Rev Proc are those the IRS historically has identified as not affecting the validity or continuity of a corporation’s S election or a subsidiary’s QSub election. The Rev Proc also clarifies S corporation qualification matters where the IRS will not rule, or will not ordinarily rule, if the matter is inherently dependent on particular facts and circumstances. The IRS has also indicated that it will not issue PLRs addressing whether an S corporation’s actions under this Rev Proc will perfect the validity or continuity of the corporation’s S election.
One significant element of the Rev Proc is the guidance for “curing” what were previously considered fatal governing provisions of the S corporation (e.g., Corporation By-Laws, Shareholder Buy-Sell Agreements, etc.). If governing provisions had the effect of not providing identical rights to all shareholders with respect to the corporation’s distributions and liquidating proceeds, it was previously understood that the corporation had more than one class of stock, and thus is not eligible for S corporation status.
Revenue Procedure 2022-19 authorizes S corporations to cure the governing provisions to result in retroactive corrective relief, if all the following requirements are met:
- 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 shareholder,
- The corporation timely filed a return on Form 1120-S for each applicable tax year, beginning with the tax year the first non-identical governing provision was adopted and through the tax year immediately before the next tax year in which the corporation sought corrective relief, and
- Certain relief statements and disclosures described in the Rev Proc are satisfied before the IRS discovers any non-identical governing provisions.
The Rev Proc also identifies the following instances where a PLR will not be ordinarily issued either because the IRS does not believe there is an existing concern with the S election (or QSub election) or because there are other methods to address the issue without securing a PLR. Those include:
- Whether there is the existence of a principal purpose to circumvent the one class of stock rule or the limitation on eligible shareholders. It appears the IRS will not rule regarding whether facts and circumstances demonstrate whether there is a principal purpose for such.
- If there’s termination of S corporation status because of a disproportionate distribution made by a corporation so long as the governing provisions of the corporation provide for identical distribution and liquidation rights.
- Whether the missing administrative letter of the IRS’s acceptance of an S election affects the validity of that election. The appropriate means for addressing this issue is not a PLR, but other administrative measures.
- Whether an S election is valid when the corporation has filed a federal income tax return that is inconsistent with the corporation’s status as an S corporation or a QSub. In other words, the Revenue Procedure sanctions taking remedial measures e.g., filing amended returns as remedial steps instead of requesting a PLR.
- Whether an S election (or QSub election) is valid solely because of certain errors or omissions on the election form.
In summary, this Rev Proc sanctions retroactive measures curing improper actions if the taxpayer takes remedial actions to restore the shareholders to the economic status they would have if the improper actions had not occurred.
Some examples include:
- Agreements and arrangements with no principal purpose to circumvent one class of stock requirement.
- An LLC was established and the operating agreement states that the original members of the LLC are entitled to preferential treatment in terms of distributions and liquidation rights regardless of current ownership. If the LLC makes an S-election and does not modify its operating agreement, they would be violating the one class of stock rule due to the provision in the operating agreement allowing for preferential distributions to the original owners. This violation would potentially lead to an inadvertent termination of the LLC’s S-election. Rev Proc 2022-19 now allows for entities with an operating agreement indicating preferential treatment to the founders that has not made preferential distributions. to now simply follow the proportionate distribution rules and one class of stock rule provided they make the appropriate changes to their operating agreement.
- Governing provisions that provide for identical distribution and liquidation rights.
An S corporation has nonresident withholding payments for one shareholder but not the other. For example, an S-corporation has a NY shareholder and a PA shareholder. The NY shareholder is a nonresident of PA, and the entity would make nonresident withholding payments on behalf of the NY shareholder. This would result in a disproportionate distribution because the NY shareholder will be receiving an additional distribution due to the nonresident withholding payment that the other shareholder did not receive. According to Rev Proc 2022-19, the entity can true up the distribution within a reasonable period rather than going through the PLR process to remedy the potential terminating event.
Revenue Procedure 2022-19 is a welcome development for S corporations and their shareholders, particularly in situations where the validity of the corporation’s S election is questioned either in day-to-day operations or in connection with due diligence procedures relative to an acquisition. This procedure provides an opportunity for S corporations to review whether S corporation termination events or conditions may have existed in the past or if they exist today. Perhaps most importantly, it provides that such potential termination events can be cured before they are discovered and become major tax problems.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
