On October 13, 2016, the IRS and Treasury issued final and temporary regulations under Section 385 providing that S corporations are exempt from all aspects of the final regulations.

Background and discussion

On April 4, 2016, the IRS and Treasury issued proposed regulations under Section 385. The proposed regulations would: (1) treat as stock certain related-party interests that would otherwise be treated as indebtedness for federal income tax purposes, (2) authorize the IRS to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes, and (3) establish extensive documentation requirements in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. The proposed regulations define "related parties" very broadly by creating two new related-party groups: (1) an "expanded group," and (2) a "modified expanded group." An S corporation could be included in an expanded group and a modified expanded group, and individuals could be included in a modified expanded group.

For a corporation to qualify as an S corporation, it may only have individuals (other than nonresident aliens), and certain trusts, estates and tax-exempt organizations as shareholders. In addition, an S corporation may only have one class of stock outstanding. The potential recharacterization of a debt arrangement as equity under the proposed regulations caused significant concerns about the effect of the regulations on a corporation's ability to qualify for or maintain S corporation status; specifically, whether the recharacterization of a debt arrangement under the regulations would cause the issuing corporation to be treated as having an ineligible shareholder or more than one class of stock.

The IRS and Treasury acknowledged these concerns in issuing the final and temporary regulations by providing that S corporations are excluded from the definition of an expanded group for all purposes of the final and temporary regulations. A Treasury fact sheet further explains that the rationale for the limited exclusions set forth in the regulations.

Implications

As a result of the exclusion of S corporations from application of the final and temporary regulations under Section 385, a corporation should be able to assess the effect of lending arrangements on its qualification as an S corporation under existing S corporation guidance. Under this guidance, a purported debt arrangement that constitutes equity under general principles of federal tax law generally only results in a second class of stock if the arrangement has as a principal purpose circumvention of an S corporation eligibility requirement. Certain safe harbors also exist.

One area of uncertainty is how the final and temporary regulations affect a corporation's ability to elect S corporation status when that corporation has indebtedness that is characterized as equity under the regulations while the corporation is a C corporation. If the indebtedness is treated as equity for purposes of assessing the corporation's ability to elect S status, it would likely preclude the corporation from electing S status because it would likely constitute a second class of stock. This interpretation seems inconsistent with the purpose of the modification to the final and temporary regulations.

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