October 12, 2022
New IRS guidance provides process for S corporations and QSubs to resolve certain common issues without making PLR requests
In Revenue Procedure 2022-19, the IRS provides a process through which S corporations and their shareholders may resolve certain "frequently encountered issues" without requesting a private letter ruling (PLR).
The guidance describes five "issues that the IRS historically has identified as not affecting the validity or continuation" of (1) a corporation's S corporation election under IRC Section 1362(a) or (2) an S corporation's election to treat its corporate subsidiary as a qualified subchapter S subsidiary (QSub) under IRC Section 1361(b)(3)(B)(ii). These five issues may now be addressed without the need to obtain a PLR. The five issues generally involve:
The guidance also provides procedures for obtaining retroactive corrective relief under IRC Section 1362(f) in certain circumstances and allowing a taxpayer to retroactively preserve S elections that are invalid or have been terminated solely as the result of "non-identical governing provisions." (A non-identical governing provision is a provision that, for federal income tax purposes, results in the S corporation's having more than one class of stock under Treas. Reg. Section 1.1361-1(l)(2)(i) because it confers different rights to distribution or liquidation proceeds.)
The IRS explains that the "taxpayer assistance procedures" provided in the revenue procedure aim to (1) reduce burdens on taxpayers and the IRS; (2) facilitate compliance with S election and QSub election rules; and (3) reduce costs and delays for completing transactions involving S corporations and QSubs. The revenue procedure includes two appendices, which provide a Sample Corporate Governing Provision Statement (Appendix A) and Sample Shareholder Statement (Appendix B), as well as a list of no-rule areas involving the validity or continuation of an S election or QSub election.
An S corporation is a small business corporation that has an S election under IRC Section 1362(a) in effect for the year at issue. Generally, a small business corporation is a domestic corporation that does not have (1) more than 100 shareholders; (2) a shareholder that is not a person (i.e., human); (3) a nonresident alien shareholder; or (4) more than one class of stock. A small business corporation must timely file a completed Form 2553. Revenue Procedure 2013-30, 2013-36 I.R.B. 173, provides a simplified method for taxpayers to request relief for late S elections.
A QSub generally is a domestic corporation for which its S corporation parent, and 100% shareholder, has made a QSub election. To make a QSub election, the parent S corporation must timely file Form 8869. Revenue Procedure 2013-30 provides a simplified method for taxpayers to request relief for late QSub elections.
If an S corporation or a QSub ceases to be eligible to be treated as such, their S corporation/QSub status will be terminated. For example, S corporation status will be terminated if the entity ceases to be a small business corporation or when its passive investment income exceeds 25% of gross receipts for three consecutive tax years and it has accumulated earnings and profits at the close of each of these years.
Under IRC Section 1362(f), a corporation will be treated as an S corporation or QSub, even if its election was not effective for the tax year at issue because it failed to meet requirements under IRC Section 1361(b) or to obtain shareholder consents or was terminated, if three requirements are met:
Treas. Reg. Section 1.1362-4(c) permits a corporation to submit a PLR request to address an invalid election or inadvertent termination. The IRS "frequently receives requests for PLRs seeking relief under [IRC Section] 1362(f) to address a potential inadvertent invalid election or termination," the revenue procedure notes. There are six categories of issues that the IRS considers resolvable without a PLR and for which Revenue Procedure 2022-19 "provides taxpayer assistance procedures":
Taxpayer assistance procedures: correcting certain election issues
Agreements/arrangements with no principal purpose to circumvent one-class-of-stock requirement
The revenue procedure explains that the IRS will not treat an S corporation as having violated the one-class-of-stock requirement of IRC Section 1361(b)(1)(D) as the result of an agreement or arrangement identified in section 2.03(1)(c) of Revenue Procedure 2022-19 if its principal purpose was not to circumvent the one-class-of-stock requirement.
Section 2.03(1)(c) of the revenue procedure describes certain agreements and arrangements that are not governing provisions and are not treated as second classes of stock as long as there was no principal purpose to use the agreement to get around the one-class-of-stock requirement. The revenue procedure notes that "because the existence of a principal purpose is inherently factual in nature, the IRS will not rule in these situations."
Implications: From 1984 to present, the IRS has published more than 350 PLRs addressing whether a corporate action has created a second class of stock, and if necessary, the Service has determined whether IRC Section 1362(f) relief was available to the taxpayer. In many of those PLRs, the taxpayer identified clauses in a buy-sell agreement, redemption agreement or commercial contractual agreement that could create a second class of stock — for example, an employment agreement that may have paid excessive compensation to a shareholder — but only if the principal purpose of the agreement was to circumvent the one-class-of-stock requirement. (See PLRs 201607001 and 9508022).
In these PLRs, the taxpayer represented to the IRS that the principal purpose of the agreement was not to circumvent the one-class-of-stock requirement, allowing the IRS to rule in the taxpayer's favor. In Revenue Procedure 2022-19, the Service has notified taxpayers that these types of rulings are unnecessary because these agreements do not create a second class of stock under the regulation, unless the principal purpose of the agreement is to circumvent the one-class-of-stock requirement. More importantly, however, the revenue procedure states that the IRS will no longer rule on whether the principal purpose requirement has been violated. While this will significantly reduce the number of PLR requests the IRS receives related to IRC Section 1361(b)(1)(D), it will also create uncertainty in merger and acquisition transactions for purchasers who (1) uncover a possible second-class-of-stock risk during the diligence process for the types of agreements described in section 2.03(1)(c) of Revenue Procedure 2022-19; and (2) no longer have the option to request a PLR seeking confirmation from the IRS that the S election is valid.
Governing provisions that provide for identical distribution and liquidation rights
A corporation is not considered to have more than one class of stock if its governing provisions provide for identical distribution and liquidation rights. Therefore, the IRS will not treat any disproportionate distributions that a corporation makes as violating the one-class-of-stock requirement if its governing provisions provide for identical distribution and liquidation rights.
Implications: The IRS has issued approximately 50 PLRs determining that distributions that differ in timing or amount do not create a second class of stock if the governing provisions of the S corporation provide identical rights to distribution and liquidation proceeds. For example, in PLR 9519035, the IRS ruled that no second class of stock existed when a taxpayer made disproportionate distributions for four consecutive years before making corrective distributions in year five, because the governing provisions of the corporation provided for only a single class of stock. Under Revenue Procedure 2022-19, these types of PLRs will no longer be necessary or permitted. This will be a welcome development for purchasers who identify through the diligence process that an S corporation target has made disproportionate distributions; once it has been confirmed that the target's governing provisions confer equal rights to distribution and liquidation proceeds, the purchaser will have certainty that the disproportionate distributions did not terminate the target's S election.
Missing shareholder consents, errors re permitted year, missing officer's signature, other inadvertent errors/omissions
If an S election fails to include the consent of a shareholder, the issue may be corrected under:
Revenue Procedure 2013-30 also provides a method for correcting an error on:
Taxpayers who are ineligible for relief under Revenue Procedure 2013-30 may submit a PLR request under IRC Section 1362(f).
Revenue Procedure 2022-19 provides that other errors or omissions on Forms 2553 and 8869 "may be corrected by explaining in writing the error(s) or omission(s) and the necessary correction(s) and submitting the written explanation to one of the following addresses (depending on the Internal Revenue Submission Processing Center with which the S corporation files its Form 1120-S) or any successor address the IRS may provide: (a) Internal Revenue Service, MS 6055, 333 W. Pershing Rd., Kansas City, MO 64108 [or] (b) Internal Revenue Service, MS 6273, 1973 N. Rulon White Blvd., Ogden, UT 84404." The new guidance emphasizes that the IRS will not issue a PLR regarding any error or omission described in this paragraph, noting that these "inadvertent errors or omissions do not impact a corporation's S election or QSub election."
The IRS will only consider issuing a PLR if the taxpayer has no other means of requesting relief and an error or omission concerns:
Implications: Taxpayers may only pursue a PLR to address problems with the Form 2553 or 8869 arising from missing consents, officer signatures or the selection of an incorrect tax year, and only when all avenues for automatic relief have been exhausted. All other "errors and omissions" may now be corrected by submitting a written explanation to the IRS. One wonders, however, if there are types of errors and omissions the IRS will not be willing to correct using this streamlined process. For example, assume an officer of an S corporation signed the Form 8869 to make a Qsub election the day before the subsidiary was transferred to the parent S corporation. Can that be corrected via this new process, or in the view of the IRS, is that more than a mere "error or omission"?
Verifying S elections or QSub elections
Replacement letters are available for missing administrative acceptance letters for S elections and QSub elections. Specifically, an S corporation and its shareholders may phone the IRS Business and Specialty Tax Line (800-829-4933), and practitioners may call the IRS Practitioner Priority Service (866-860-4259).
Implications: The IRS will not issue PLRs regarding any missing administrative acceptance letter, because the absence of such a letter has never resulted in an inadvertent termination of an S or Qsub election.
Addressing a federal income tax filing inconsistent with S election or QSub election
An S corporation, or a parent S corporation of a QSub, that filed a federal income tax return for a tax year that is inconsistent with the S corporation's or QSub's status must file an appropriate federal income tax return for open tax years consistent with its status. The IRS will not issue PLRs with regard to any inconsistent return filing.
Because these tax return inconsistencies would not terminate an S election or QSub election, (1) the corporation's distributions and other transactions "will be treated consistent[ly] with its status as an S corporation or a QSub" and (2) a QSub's income/deductions "will be treated as income or deductions of the parent S corporation and distributions between the QSub and its parent will be disregarded."
Retroactively correcting non-identical governing provisions
Definitions. This section of the revenue ruling defines certain terms, including:
Retroactive corrective relief procedures. If an S election is invalid or terminated solely due to non-identical governing provisions, the S corporation will be treated for federal income tax purposes as continuing from the adoption date of the first non-identical governing provision that invalidated or terminated the corporation's S election.
Eligibility. A small business corporation and each of its applicable shareholders are eligible for this corrective relief if these conditions are met:
Corrective relief statements. The revenue procedure (section 3.06(2)(c)) spells out a series of specific requirements that must be met in completing corrective relief statements.
Alternative relief. An S corporation or applicable shareholder that does not qualify for corrective relief under this section of the revenue ruling may submit a PLR request that explains "each reason why the requirements for corrective relief under [section 3.06 of Revenue Ruling 2022-19] could not be satisfied."
Implications: As we learned earlier in this Alert, the IRS has repeatedly ruled that disproportionate distributions by S corporations do not create a second class of stock if the corporation's governing provisions confer equal rights to distribution and liquidation proceeds to all shares of stock. The opposite is also true, however: an S corporation can make every distribution proportionate to the penny, but if the governing provisions confer differing rights to distribution and liquidation proceeds, a second class of stock exists, and the S election terminates, necessitating the need for relief via IRC Section 1362(f) and the PLR process.
In recent years, the IRS has been asked to provide IRC Section 1362(f) relief in a string of similar circumstances where a second class of stock has been created by the corporation's governing provisions. In these PLRs, a state-law LLC has checked the box under Treas. Reg. Section 301.7701-3 to be treated as an S corporation. The operating agreement of the state law LLC, however, has contained standard boiler plate language that created a second class of stock by, for example, requiring liquidating distributions to be made in accordance with the positive balances of the partner's capital accounts. (See PLRs 201815003, 201840004, 201904001 and 202042001).
Although IRC Section 1362(f) relief was granted in each case — contingent on the taxpayer's removing the offending language — Revenue Procedure 2022-19 removes the need for taxpayers who have non-identical language in their governing provisions, but who have made proportionate distributions, to pursue the costly and time-consuming PLR process.
To use the streamlined process available in section 3.06 of Revenue Procedure 2022-19, however, the corporation must not have made any distributions that differ in amount or timing during the period beginning on the date the non-identical governing provision was adopted and ending on the date the non-identical governing provision was removed or modified.
In lieu of the PLR process, section 3.06 of Revenue Procedure 2022-19 instructs the S corporation to complete a Corporate Governing Provision Statement and its shareholder to complete a Shareholder Statement. Examples of each statement are provided in Appendices A and B. Interestingly, it appears that the statements are not mailed to the IRS or attached to the Form 1120-S, but rather are simply retained as part of the corporation's records.
In summary, section 3.02 of Revenue Procedure 2022-19 permits a corporation to obtain relief from a second class of stock without going through the PLR process if the corporation has a history of disproportionate distributions but its governing provisions confer equal rights to distributions and liquidation proceeds. Then, section 3.06 of Revenue Procedure 2022-19 permits a corporation to obtain relief from a second class of stock without going through the PLR process if the corporation has non-identical language in the governing provisions but has made proportionate distributions throughout the period in which the non-identical language was in place. Corporations with both non-identical language in their governing provisions and a history of disproportionate distributions, however, must undertake the PLR process to seek relief under IRC Section 1362(f).
Section 4 of the revenue ruling lists applicable areas in which the IRS will not (1) issue PLRs or (2) ordinarily issue PLRs.
The IRS will not issue PLRs on whether a principal purpose exists for purposes of the one-class-of-stock requirement "because such a determination is inherently factual in nature."
The IRS also will not issue PLRs under IRC Section 1362(f) on the validity or continuation of an S election or QSub election addressed by the relief provided in Revenue Procedure 2022-19, because this "would comprise a 'Comfort Ruling.'"
Revenue Ruling 2022-19 amplifies and modifies Revenue Procedure 2022-3 in part by stating that the IRS will not ordinarily issue a PLR in areas on which Revenue Procedure 2022-19 provides guidance.