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The IRS has issued final regulations (TD 9914) on eligible terminated S corporations (ETSCs) and distributions of money from those corporations after the post-termination transition period (PTTP). The final regulations implement provisions added by the Tax Cuts and Jobs Act (TCJA) and adopt with some modifications proposed regulations issued in 2019.

Background

The TCJA added two provisions on ETSCs to the Code in IRC Sections 481(d) and 1371(f). IRC Section 481(d)(2) defines an ETSC as a C corporation (i) that was an S corporation on December 21, 2017, (ii) that revoked its S election during the two-year period beginning on December 22, 2017, and (iii) whose stock was owned, on the date of the revocation of its S election and on December 22, 2017, by the same shareholders in identical proportions.

Under IRC Section 481(d)(1), an ETSC may take into account any IRC Section 481 adjustments attributable to the revocation of an S election over the IRC Section 481(d) inclusion period — i.e., the six-tax-year-period beginning with the year of change.

IRC Section 1371(f) extends the period during which shareholders of an ETSC can benefit from its accumulated adjustments account (AAA) generated during the corporation's former status as an S corporation. The AAA generally approximates undistributed S corporation earnings and represents the amount that the corporation can distribute to its shareholders (generally tax-free) before the corporation's accumulated earnings and profits (AE&P) (generally taxable as dividends). Under IRC Section 1371(f), if an ETSC distributes money after the PTTP, the AAA is allocated to the distribution and the distribution is chargeable to AE&P in the same ratio as the amount of the AAA bears to the amount of AE&P.

In November 2019, the IRS issued proposed regulations (REG-131071-18) on ETSCs under IRC Sections 481 and 1371.

Final regulations

The final regulations adopt the 2019 proposed rules with some modifications in response to comments received, including modifications to the date of revocation of an S election for purposes of qualifying as an ETSC under IRC Section 481(d) (described later). The final regulations are mostly consistent with the proposed regulations with respect to the mechanics of IRC Section 1371(f), including shareholders eligible to receive qualified distributions, implementation of ETSC proration, and character and effect of distributions during the ETSC period.

Qualification as an ETSC

Under IRC Section 1362(d)(1), the revocation of an S election within the first 2 ½ months of a tax year is generally effective as of the beginning of the tax year; if it is made after the first 2 ½ months of the tax year, the revocation is effective as of the beginning of the next tax year. A revocation may, however, specify a prospective effective date, in which case the revocation will be effective on the specified date.

As discussed previously, a corporation must revoke its S election within the two-year period beginning on December 22, 2017, to be an ETSC. The final regulations provide the following rules for this two-year period:

1.   Like the proposed regulations, the final regulations consider the revocation requirement to be satisfied if the revocation of an S election is validly made during the two-year period beginning on December 22, 2017, even if the effective date for the revocation occurs after the conclusion of that two-period.

2,   For purposes of complying with the revocation requirement and shareholder-identity requirement for a revocation that is effective retroactive to the beginning of the tax year in which the revocation was made, a corporation may test compliance with those requirements on either the day of the revocation or its retroactive effective date.

3.   Because the last day of the two-year period beginning on December 22, 2017, is a Saturday (December 21, 2019), the final regulations also clarify that IRC Section 7503 will apply to treat a revocation made on December 23, 2019, as made during the two-year period.

Inapplicability of IRC Section 481(d) to qualified subchapter S subsidiaries (QSubs)

For an ETSC, IRC Section 481(d) takes any adjustment required under IRC Section 481(a) (relating to a change in accounting method) that is attributable to the corporation's revocation of its S election into account ratably over a six-tax year period, beginning with the year or change. IRC Section 481(d) was primarily enacted to address when a cash-basis S corporation was required to change to an accrual method as a result of terminating its S election.

If an S corporation owns a QSub as of the effective date of the revocation of its S election, the QSub election in effect for the subsidiary also terminates, and the corporation is treated as contributing the subsidiary's assets (subject to liabilities) to a newly formed C corporation in an IRC Section 351 exchange. If the former QSub was a cash-basis taxpayer, then the assets deemed contributed would likely include accounts receivable for which the subsidiary would have no basis, resulting in income recognition when the receivables are collected (likely in the first C year). Several commentators requested that the IRS and Treasury extend the IRC Section 481(d) inclusion period to an accrual-method ETSC corporate subsidiary that operated as a cash-method QSub of a cash-method S corporation prior to the revocation of the parent's S election. The IRS and Treasury did not adopt this suggestion, noting that IRC Section 481 does not apply to an IRC Section 351 transaction.

Applicability of PTTP and ETSC period to S corporations without accumulated earnings and profits (AE&P)

IRC Section 1371(e) and (f) relate to distributions from a former S corporation's AAA following the termination of its S election. As a technical matter, an S corporation that does not have AE&P is not required to maintain an AAA. Accordingly, commentators requested that the IRS and Treasury confirm that the PTTP and ETSC distribution rules apply to former S corporations without AE&P. The IRS and Treasury did not address this request in the final regulations but confirmed in the Preamble that the PTTP and ETSC rules apply to former S corporations without AE&P, noting that one of the examples in the final regulations involved a former S corporation without AE&P.

Application of the PTTP and ETSC distribution rules to new shareholders

Before Treas. Reg. Section 1.1377-2(b)'s amendment by these final regulations, the special treatment provided under IRC Section 1371(e)(1) (with respect to distributions of money during a corporation's PTTP) was limited solely to those shareholders who were shareholders of the corporation at the time that it terminated or revoked its S election (the no-newcomer rule). The final regulations amend Treas. Reg. Section 1.1377-2(b) to eliminate the no-newcomer rule. Thus, persons becoming shareholders after the day on which a corporation's S election terminates are eligible for the special treatment of distributing money during a corporation's PTTP. Consistent with the proposed regulations, the final regulations also eliminate the no-newcomer rule for purposes of the ETSC distribution provisions.

Rules relating to the allocation of ETSC distributions between the AAA and AE&P

The rules in the final regulations on the allocation of ETSC distributions between the AAA and AE&P are substantially similar to those provided in the proposed regulations.

Effective dates

The final regulations generally apply to tax years beginning after their date of publication in the Federal Register. A corporation may, however, choose to apply certain rules to tax years beginning before that date, including elimination of the no-newcomer rule for purposes of PTTP distributions for periods for which the statute of limitations on assessment remains open, provided all shareholders report consistently and the corporation continues to apply those rules in subsequent tax years.

Implications

For purposes of sourcing distributions, the final regulations generally adopt what the Preamble to the proposed regulations referred to as a snapshot approach. Under this approach, the proportion of cash distributions during the ETSC period is generally based on a fixed ratio, which is calculated as the AAA as of the day the corporation is first treated as a C corporation as a result of the revocation, divided by the sum of AAA and AE&P as of that day. This ratio remains constant until either (i) the corporation runs out of AAA, in which case its ETSC period ends, or (ii) the corporation runs out of AE&P, at which time the ratio becomes 1. The final regulations also adopt what the Preamble to the proposed regulations describes as the IRC Section 1371(f) Priority Rule, so that the special ETSC rules apply before the normal C corporation distribution rules (which, for example, would source distributions to current E&P first).

The elimination of the no-newcomer rule for purposes of the PTTP distribution rules is a welcome development. As noted previously, a corporation may elect to apply Treas. Reg. Section 1.1377-2(b) without the no newcomer rule for tax years in which the period of limitations on assessment remains open. A corporation that distributed money during a PTTP to new shareholders for which the tax year remains open should consider whether amended returns should be filed by it and its shareholders to take advantage of the elimination of the no-newcomer rule. In addition to amending income tax returns, information returns will likely also need to be amended.

The final regulations on the ETSC distribution rules are taxpayer-favorable with the adoption of the snapshot approach and the IRC Section 1371(f) Priority Rule. ETSCs should consider taking advantage of these rules to make tax-free or partially tax-free distributions to their shareholders.

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