Tax rules relating to S corporations are a frequent and often time-consuming problem. With the release of Revenue Procedure 2022-19[1], the IRS just made it easier for S corporations to confirm compliance with tax rules and also has eased the administrative burden on the IRS in dealing with these taxpayers. The Internal Revenue Code provides that relief for invalid elections or terminations may be granted based on certain requirements which include circumstances where the IRS determines the ineffective election or termination was inadvertent.[2]
Private letter rulings (PLR’s) are regularly issued offering taxpayers relief for noncompliance with tax rules applicable to S corporations.[3] While these PLR’s appear to be granted almost as a matter of course, to obtain a PLR requires a taxpayer to pay an IRS user fee, incur the expense of having the ruling request prepared, and potential delay (or loss) of a beneficial transaction.[4] For the IRS, continued ruling requests require use of limited agency resources. Rev. Proc. 2022-19 helps both taxpayers and the IRS by easing these burdens.
Areas Addressed and Procedures Provided
Rev. Proc. 2022-19 addresses six areas where taxpayers otherwise would have needed to seek a PLR:
One class of stock requirement
In order to qualify as an S corporation, the corporation must have only one class of stock which confers identical rights to distributions and liquidation proceeds.[5] Whether identical rights to distributions and liquidation proceeds exist is determined based on the corporate charter, articles of incorporation, bylaws, applicable state law, and other binding agreements relating to distribution and liquidation proceeds.[6] These are generally referred to as “governing provisions” under the regulations.
Other agreements or arrangements may be considered to create a second class of stock as well if a principal purpose is to avoid the single class of stock requirement.[7] Such agreements or arrangements may include buy-sell agreements, agreements relating to transfer restrictions, debt instruments, and short-term unwritten advances. Under Rev. Proc. 2022-19, as long as there was no principal purpose to use the instrument, obligation, or arrangement to circumvent the single class of stock requirement, the IRS will not treat the S corporation as violating the single class of stock requirement. As such, the corporation’s election to be taxed as an S corporation will not be terminated. The IRS will not issue rulings in these situations.
Disproportionate distributions
Even if the governing provisions or other arrangements/agreements do not create a second class of stock, an S corporation may actually make disproportionate distributions notwithstanding any governing provision providing allowing such distributions. A disproportionate distribution (including actual, constrictive, and deemed distributions) is one which differs in timing or amount from a distribution with respect to other shares of stock.[8] The regulation states: “Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.”[9]
In order to provide clarity about what the phrase “be given appropriate tax effect” means (i.e. does it mean the S election is terminated for having a second class of stock), Rev. Proc. 2022-19 provides that disproportionate distributions will not cause termination of an S election as long as the governing provisions provide for identical distribution and liquidation rights. The IRS will not issue rulings in these situations.
Certain inadvertent errors on Form 2553 or Form 8869
In order to make an S election or to elect for an S corporation to be treated as a disregarded subsidiary of its corporate parent (a QSub), the corporation files either Form 2553 or Form 8869, respectively. Generally, errors on such forms will not cause the S election to be invalid. However, errors in obtaining shareholder consent or designating a proper tax year will invalidate an S election.[10] A common example of this error is only obtaining the signature of one spouse when interests in the corporation are held as community property which requires the signature of both spouses.
If the error is the result of missing shareholder consent, Rev. Proc. 2022-19 allows the error to be corrected by either: (a) submitting the missing signature(s) within the time during which an extension of time for filing would be allowed;[11] (b) obtaining simplified late filing relief under Rev. Proc. 2013-30; or (c) obtaining automatic relief under Rev. Proc. 2004-35 for late consents in community property states. If the error is for lack of providing a valid tax year or missing the signature of an authorized officer, then Rev. Proc. 2002-19 provides that the error should be corrected by following the simplified relief procedures under Rev. Proc. 2013-30. If none of these procedures can apply, such as when the requirements to fit within Rev. Proc. 2013-30 are not satisfied, the taxpayer still may be required to obtain a PLR to correct the error.
Other inadvertent errors or omissions may be corrected by submission of a written explanation to the IRS service center in Ogden, UT or Kansas City, MO. For these errors or omissions, the IRS will not issue a PLR.
Missing administrative acceptance letter for S election or QSub election
Normally, following acceptance of a Form 2553 or Form 8869, the IRS issues a notice acknowledging acceptance of the filing.[12] Sometimes, taxpayers never receive these written notices or lose the notice. When taxpayers are required to prove to a third party the validity of an S election or QSub election and lack this acknowledgement, they often were put in a position of needing to obtain a PLR to confirm a valid election.
Under Rev. Proc. 2022-19, the IRS has provided procedures to obtain a replacement letter. Those may be obtained by the S corporation or shareholders of the S corporation by contacting the IRS Business and Specialty Tax Line at 800-829-4933. For tax practitioners, the replacement letter may be obtained by contacting IRS Practitioner Priority Service at 866-860-4259.
Filing a federal income tax filing inconsistent with an S election or QSub election
An S corporation files its annual income tax return by submitting a Form 1120S to the IRS. A QSub does not file an income tax return since it is treated as a disregarded entity. However, taxpayers occasionally submit filings inconsistent with either an otherwise valid S election or QSub election. Although the regulations do not list inconsistent filings as causing revocation of a valid election,[13] taxpayers often seek confirmation by requesting a PLR.
Rev. Proc. 2022-19 provides that the S corporation (or QSub parent) must file a federal income tax return consistent with its tax status for any open tax years whether that is as an S corporation, a QSub parent, or QSub. The IRS will treat all transactions and distributions as being made by an S corporation or QSub as appropriate rather than as reported on the inconsistent return. The IRS will not issue rulings in these situations.
Non-identical governing provisions
According to Rev. Proc. 2022-19, a “non-identical governing provision” is a governing provision, alone or as part of another governing provision, that results in the S corporation having more than one class of stock. These provisions would conflict with the requirement that the governing provisions of an S corporation provide for identical distribution and liquidation rights (as discussed in the section related to disproportionate distributions). S elections made while there are non-identical governing provisions are invalid. The creation of non-identical governing provisions causes an existing S election to terminate. A typical example, and one where a number of PLR’s are issued, is adoption of an operating agreement containing partnership tax provisions related to distributions and liquidations for an LLC that desires to be taxed as an S corporation.
Rev. Proc. 2022-19 allows the existence of non-identical governing provisions to be corrected without the need to obtain a PLR. In order to be eligible for this simplified correction procedure the following must be satisfied: (a) the corporation has or had one or more non-identical governing provisions; (b) the corporation has not made a disproportionate distribution (actual or deemed); (c) the corporation files IRS Form 1120S for each year beginning when the first non-identical governing provision was adopted and through the year immediately preceding the year in which the corporation requests relief, and (d) procedural requirements for requesting relief are satisfied. With respect to procedural requirements, Rev. Proc. 2022-19 requires certain information to be provided and statements be confirmed by the corporation and each “applicable shareholder” (generally, the persons who were shareholders at any time when the non-identical governing provision existed). These are filed by submitting a Corporate Governing Provision Statement and a Shareholder Statement, samples of each being attached as an Appendix to the Rev. Proc. If these items cannot be satisfied, then a PLR may be requested.
Conclusion
The ability to obtain relief from the requirement of a PLR will be a significant benefit for S corporations and their shareholders. The costs and delay of ruling requests, where those requests can be avoided or will not be granted under Rev. Proc. 2022-19, are significantly mitigated. Certainly, there will be times where a PLR is preferred, such as where the buyer in an M&A transaction wants the certainty of a positive ruling with respect to a potential area of non-compliance. In those cases, the issues would likely need to be addressed in other ways such as in representations, warranties, and indemnifications. Regardless, as cited in Rev. Proc. 2022-19, the time and costs to confirm intended tax treatment have now been eased. This should be a good set of new guidance for both taxpayers and the IRS.
[1] www.irs.gov/pub/irs-irbs/irb22-41.pdf.
[2] IRC § 1362(f).
[3] In Rev. Proc. 2022-19, the IRS states approximately 80 PLR’s are requested per year related to issues addressed in the Rev. Proc. They estimate another 120 S corporations need guidance but elect not to pursue assistance due to the costs of a PLR.
[4] In Rev. Proc. 2022-19, the IRS estimates the costs of a PLR is approximately $108,000 ($38,000 user fee, $20,000 preparer PLR fee, and $50,000 preparer due diligence fee).
[5] See. IRC § 1361(b)(1)(D) and Treas. Reg. § 1.1361-1(l)(1).
[6] Treas. Reg. § 1.1361-1(l)(2)(i).
[7] Treas. Reg. § 1.1361-1(l)(2)(ii)(A), -1(l)(4)(ii)(A), -1(l)(4)(ii)(B)(1), -1(l)(4)(B)(2).
[8] Treas. Reg. § 1.1361-1(l) and (2).
[9] Treas. Reg. § 1.1361-1(2)(i).
[10] See IRC § 1362(a)(2) and Treas. Reg. § 1.1378-1.
[11] Treas. Reg. § 1.1362-6(b)(3)(iii).
[12] For a Form 2553, this is by a CP261 Notice. For a Form 8869, this is by a CP279 Notice to the parent corporation and a CP249A Notice to the subsidiary.
[13] IRC § 1362(d) and Treas. Reg. § 1.1361-5(a).
