Editor: Greg A. Fairbanks, J.D., LL.M.
The IRS released Rev. Proc. 2022-19, which expands Rev. Proc. 2013-30 (providing a simplified method for taxpayers to request relief for late elections by S corporations, qualified Subchapter S subsidiaries (QSubs), electing small business trusts (ESBTs), and qualified Subchapter S trusts (QSSTs)). Rev. Proc. 2022-19 also amplifies Rev. Proc. 2004-35 (providing automatic relief for certain taxpayers requesting relief for late shareholder consents for S elections in community property states). In addition, Rev. Proc. 2022-19 adds certain no-rule areas with respect to IRS letter ruling requests, consistent with the guidance provided in the revenue procedure.
The guidance focuses on six issues: (1) nonidentical governing provisions; (2) principal-purpose determinations regarding the one-class-of-stock requirement; (3) disproportionate distributions; (4) certain inadvertent errors or omissions on Form 2553, Election by a Small Business Corporation, or Form 8869, Qualified Subchapter S Subsidiary Election; (5) missing administrative or acceptance letters for an S or QSub election; and (6) the requirement to file returns consistent with an S election.
Self-help relief available for certain nonidentical governing provisions
The governing provisions of an S corporation cannot provide for disproportionate distribution or liquidation rights (i.e., nonidentical governing provisions) among any shares of stock, or else the S corporation will have two classes of stock and will be ineligible to have an S election (Regs. Sec. 1.1361-1(l)). This most often applies in the context of a limited liability company with an S election that has governing provisions more common to those of a partnership, such as distribution or liquidation rights based upon capital account balances rather than pro rata among the shares of stock.
Rev. Proc. 2022-19 provides a new method for relief for nonidentical governing provisions. To qualify for relief, the S corporation and its shareholders must satisfy the following requirements:
- The corporation has or had one or more nonidentical governing provisions;
- The corporation has not made, and for federal income tax purposes is not deemed to have made, a disproportionate distribution to an applicable shareholder;
- The corporation timely filed (defined as filed within six months after its original due date, excluding extensions) a return on Form 1120-S, U.S. Income Tax Return for an S Corporation, for each tax year of the corporation, beginning with the tax year in which the first nonidentical governing provision was adopted and through the tax year immediately preceding the tax year in which the corporation made a request for corrective relief; and
- Before any nonidentical governing provision is discovered by the IRS, all of the requirements of the revenue procedure are satisfied.
To request relief, the corporation must prepare a statement of all the relevant facts, signed by a corporate officer, and each applicable shareholder must consent to the election. The corporation will prepare an explanation of how each nonidentical governing provision was discovered and each action taken to correct or remove it. To demonstrate reasonable cause for relief, the description must include each action taken by the corporation and each applicable shareholder to establish that the corporation and shareholder acted reasonably and in good faith in correcting or removing each nonidentical governing provision upon discovery.
Applicable shareholders include the corporation’s current or former shareholders who own or owned stock of the corporation at any time during the period (1) beginning on the date on which the nonidentical governing provision was adopted and (2) ending on the date on which the nonidentical governing provision was removed or modified to comply with the one-classof- stock requirement.
The IRS provides an example of a corporate governing provision statement in the revenue procedure’s Appendix A and an example of a shareholder statement in Appendix B.
The corporation will retain the corporate governing provision statement, the shareholder statement(s), and the revised governing provisions in its corporate records. There is no need to notify the IRS of the corporation’s identification of the nonidentical governing provisions, the change in governing provisions, or the qualification for relief under Rev. Proc. 2022-19. Rather, if the IRS examines the corporation, then the corporation will provide the documentation to support meeting the requirements for relief under the revenue procedure.
If the S corporation or applicable shareholder does not qualify under Rev. Proc. 2022-19, then the S corporation or shareholder can request a letter ruling.
Principal-purpose determinations regarding the one-class-of-stock requirement
A corporation with more than one class of stock does not qualify as a small business corporation (Sec. 1361(b)(1)(D) and Reg. Sec. 1.1361-1(l)(1)). Generally, a corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). A commercial contractual agreement is not a binding agreement relating to distribution and liquidation proceeds and therefore is not a governing provision, unless its principal purpose is to circumvent the one-class-ofstock requirement.
Other agreements and arrangements between or among an S corporation and its shareholders may be treated as second classes of stock under the relevant regulations (e.g., buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements; see Regs. Secs. 1.1361-1(l)(2)(iii)(A)). However, this depends partly on whether the agreement or arrangement’s principal purpose is to circumvent the one-class-of-stock requirement or otherwise change shareholders’ rights to proceeds of distributions and liquidation.
The IRS also added a no-rule provision on whether a principal purpose of an arrangement is to avoid the single-class-of-stock requirement to be an S corporation, because that determination is inherently factual.
Disproportionate distributions
The governing provisions of an S corporation cannot provide for disproportionate distribution or liquidation rights among any shares of stock, or else the S corporation will have two classes of stock and will be ineligible to have an S election. This is further broken down between a permanent and a timing difference in distribution rights. An S corporation is not allowed to have permanent differences in distribution and liquidation rights. However, there can be timing differences of when the distributions among different shares of stock are allowed. For a timing difference to be acceptable to the IRS, there must be “an appropriate tax effect in accordance with the facts and circumstances” (Regs. Sec. 1.1361-1(l) (2) (i)).
A factual question arises whether an appropriate tax effect has been provided to a timing difference in the distributions and, if not, whether this will terminate the S election. The IRS in the revenue procedure clarified its position, stating that it will not treat any disproportionate distribution as violating the one-class-of-stock requirement so long as the governing provisions provide for identical distribution and liquidation rights among shares of stock. In addition, the IRS provided a no-rule area on whether an appropriate tax effect has been provided when there are timing differences in distributions.
This eliminates the risk of how to apply the appropriate-tax-effect rule from a second-class-of-stock analysis, but it does not eliminate it from an income tax perspective. A taxpayer should still consider how to give appropriate tax effect to timing differences in distributions, based upon the specific facts and circumstances that require a difference in the timing of the distributions.
Inadvertent errors or omissions on Form 2553 or Form 8869
An inadvertent error or omission on Form 2553 or Form 8869 does not invalidate an S election or a Qsub election unless the error or omission is with respect to a shareholder consent, a selection of a permitted year (as defined in Sec. 1378(b) and Regs. Sec. 1. 1378-1(b)), or an officer’s signature. Guidance is already available to correct each of these specified errors if certain requirements can be met. If the requirements cannot be met, then the taxpayer can request a letter ruling. Rev. Proc. 2022-19 provides a method to correct errors that are not among the items specified. While the revenue procedure does not provide examples, this will likely include relief for an incorrect address, incorporation date, or state of incorporation. It is unclear whether an incorrect employer identification number or entity name would be a correctible error, but it might be, if the Form 2553 is otherwise clear regarding to which entity the election relates.
To perfect the Form 2553 or Form 8869, the taxpayer must write to an IRS service center explaining the error(s) or omission(s) and the necessary correction(s). Note that Rev. Proc. 2022-19 provides specific addresses where the request should be mailed, which differ from where a Form 2553 or Form 8869 is currently filed.
Missing administrative acceptance letter for S election or Qsub election
When a taxpayer files Form 2553 for an S election or Form 8869 for a Qsub election, the IRS will provide a written acknowledgment of its acceptance (CP261 for an S election; for a Qsub election, CP279 to the parent and CP279A to the subsidiary). The written acknowledgment is an administrative item that does not affect the election. A new letter can be requested by calling the IRS.
A letter ruling is not available with regard to any missing administrative acceptance letter.
Federal income tax return filing inconsistent with election
Rev. Proc. 2022-19 verifies that filing an incorrect income tax return (e.g., Form 1065, U.S. Return of Partnership Income, or Form 1120, U.S. Corporation Income Tax Return) inconsistent with an S or Qsub election does not by itself terminate the validity of the S or Qsub election. The revenue procedure provides that the taxpayer must file a federal income tax return for open tax years consistent with its status. (Note that, depending upon the type or return filed and the facts and circumstances surrounding the filing, the statute of limitation may not have started.)
The IRS will not issue a letter ruling to address any inconsistent return filing. This raises concerns about how to perfect the entity’s records with an inconsistent tax filing in closed statute years. The IRS provides that the corporation’s distributions and other transactions will be treated as consistent with its status as an S corporation or a Qsub, as appropriate. Thus, a Qsub’s income or deductions will be treated as income or deductions of the parent S corporation, and distributions between the Qsub and its parent will be disregarded. However, there may be additional technical issues that will need to be resolved, depending upon the facts and circumstances.
Editor Notes
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
