New IRS Guidance Provides Clarification and Simplified Procedures for S Corporations, Including LLCs, to Address Common Missteps
Revenue Procedure 2022-19 (the “Revenue Procedure”), issued by the IRS, provides clarification and describes simplified procedures that allow S corporations, including limited liability companies (“LLCs”) that have made an S election and their owners, to resolve frequently encountered missteps — often without requesting a time-consuming and costly private letter ruling (“PLR”).
S corporations are subject to many restrictions that can create unintended “foot faults,” resulting in material adverse tax consequences. Many times these issues are discovered during the sale process as part of a prospective buyer’s due diligence and may require requests for PLRs that may postpone or even derail a potential sale transaction.
One of the most common issues relates to LLCs that elect to be classified as S corporations. LLCs are typically classified as partnerships for tax purposes, and their operating agreements include language that provides for different rights to distributions (referred to as “non-identical governing provisions”). Oftentimes, when an LLC elects to be classified as an S corporation, the owners of the LLC use an “off-the-shelf” operating agreement that includes partnership tax provisions. These provisions, in many instances, create a “second class of stock,” thereby invalidating the S election even if the LLC never made a non-pro rata distribution.
The Revenue Procedure provides clarification and a simplified procedure addressing this issue along with five other common taxpayer missteps. A corporation and each of its applicable shareholders are eligible for this corrective relief for “non-identical governing provisions” if all of the following requirements are satisfied:
- 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 or former shareholder;
- The corporation timely filed an IRS Form 1120-S for each applicable tax year, beginning with the tax year in which the first non-identical governing provision was adopted and through the tax year immediately before the tax year in which the corporation sought corrective relief;
- The taxpayer satisfied certain other requirements of the Revenue Procedure prior to the IRS discovering the non-identical governing provision.
The five other common missteps that qualify for a simplified relief procedure include the following:
- Commercial contracts (e.g., buy-sell agreements, redemption agreements, debt agreements, etc.) with no principal purpose to circumvent the one-class-of-stock requirement. The IRS will not treat an S corporation as violating the one-class-of-stock requirement as a result of a commercial contract that does not have a principal purpose to circumvent the one-class-of-stock requirement.
- Disproportionate distributions despite having “governing provisions” providing for identical distributions and liquidation rights. The IRS will not treat any disproportionate distributions made by a corporation as violating the one-class-of-stock requirement so long as the “governing provisions” of the corporation provide for identical distribution and liquidation rights.
- Certain inadvertent errors or omissions on IRS Form 2553 (S election) or IRS Form 8869 (qualified subchapter s subsidiary election or QSub election). An inadvertent error or omission on IRS Form 2553 or IRS 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 the Internal Revenue Code of 1986, as amended (the “Code”)), as defined in the Code), or an officer’s signature, which now can be corrected under a simplified procedure.
- Missing administrative acceptance letter for S election or QSub election. During the tax diligence process, a buyer will request to review the S election, the acceptance letter, and in many cases, the seller cannot locate the letter, which may lead to questions as to whether the S election was ever sent or accepted by the IRS.
- Tax return filing inconsistent with an S election or QSub election. Occasionally, a corporation files a federal income tax return that is inconsistent with the corporation’s status as an S corporation or a QSub. Although an inconsistent federal income tax return filing can create several complications for the filer, nothing in the Code or Treasury Regulations thereunder provides that such a filing affects the validity of a corporation’s S election or QSub election.
Issues concerning the validity of a target’s historical S corporation status have the potential to affect deal pricing, drafting the purchase agreement, and the form of the transaction ultimately implemented. An invalid S corporation election can result in a buyer bearing the target’s historical unpaid corporate-level taxes (after the closing) indirectly as the owner of the target corporation or directly as the transferee of all of the corporation’s assets. Buyers normally mitigate this risk by requiring that the purchase agreement include a tax indemnity relating to the target’s qualification as an S corporation and requiring the seller to place in escrow a portion of the purchase price to the extent any potential tax exposure with respect to the target’s S corporation status is discovered during tax diligence. In addition, an invalid S corporation election may result in a buyer not receiving an asset basis step-up under section 338(h)(10)/336(e) of the Code, which election is predicated on a valid S corporation target. In response to this risk, a buyer may insist on structuring the transaction as an actual asset sale or use of an “F reorganization” structure rather than an acquisition of the stock of the S corporation in order to receive a step-up in the assets of the target S corporation.
We expect the clarification and simplified procedures contained in the Revenue Procedure to allow for speed and efficiency in due diligence and transactions, as well as reduce burdens on S corporations, their shareholders, and tax professionals, including a reduced amount of tax indemnities and escrowed funds relating to a target’s historical S corporation status and an increased willingness of the parties to structure acquisitions of an S corporation under Sections 338(h)(10)/336(e) of the Code.
For further information regarding the implications of the Revenue Procedure and how to take advantage of the simplified IRS procedures, please contact the authors or your Mintz relationship attorney.