Sale of S Corporation Appears to Have Been Put in Hold Until IRS Rules Ineffective S Election Was Inadvertant, S Status Recognized

I’ve often run into CPAs when discussing S corporations and the various ways they can lose their S status who remark that, while that may be true, they’ve never seen the IRS actually revoke the corporation’s status on an exam, or even question the issue.  While that may be true, the author notes that a lot of private letter ruling requests are paid for to correct issues that would have terminated the S status, but which the IRS had not become aware.

A major reason for this is noted explicitly in PLR 201935010.[1]  The problem often arises when a buyer is interested in acquiring the business and during the review of the organization, the potential liability for taxes for prior years comes to light due to an issue that rendered the organization ineligible to have received or to have continued with S corporation status.

In this case, the problem was the accidental creation of a second class of stock.  Per IRC §1361(b)(1)(D), one of the conditions for a corporation to be an S corporation is that the corporation only have a single class of stock, as defined under federal law.

In this case, an issue arose from recapitalizations of the corporation.  The ruling describes these two recapitalizations as follows:

On Date2, X undertook a recapitalization, and X’s Board of Directors amended X’s Articles of Incorporation to divide X’s common stock into N1 shares of class A stock and N2 shares of class B stock. The class A shares retained voting power and the class B shares held no voting power. The class A and class B shares otherwise conferred identical rights to distribution and liquidation proceeds. On Date3, X’s Board of Directors amended X’s Articles of Incorporation for a second time to change the liquidation rights of X’s stock. After this amendment, the class A and class B shares were entitled to receive equal shares of any assets of X in liquidation until the amount of $N3 had been paid to each share. Upon reaching $N3 in liquidation proceeds per share, the class B shares were entitled to receive the balance of any remaining assets of X.[2]

Those who haven’t looked into the one class of stock rule may believe the first recapitalization was the problem--after all, when that was over the corporation had issued “class A” and “class B” stock.  A reader might think that since there are two classes of stock, that violates the prohibition on issuing more than one class of stock.  But that is not the case.

Reg. §1.1361-1(l)(2)(i) treats stock as being of one class for purposes of meeting the S corporation one class of stock rule so long as the shares have identical rights to distributions and in liquidation.  A difference in voting rights, while a key differentiator of classes for state corporate law purposes, is not relevant in an S corporation context.

Rather, it is the second recapitalization that made this corporation ineligible to have S status.  Even though the differing rights had never been triggered, their existence rather than use barred the corporation from obtaining or retaining S status.

Ignorance being bliss, the corporation went ahead and made an S election with those rights in place, an election the IRS never seems to have questioned:

On Date4, X filed an election to be taxed as an S corporation. X represents that at time this election was filed, X’s Board of Directors were either unaware or had forgotten that the distribution and liquidation rights had been changed and differed for class A and class B shares as a result of the Date3 amendment to X’s Articles of Incorporation. In addition, X represents that X’s tax advisors were unaware of this amendment. On Date4, X had two shareholders, A and B. A and B remained the only shareholders of X from Date4 through Date6.[3]

All good things must come to an end, and the corporation’s blissful ignorance was shattered when the shareholders were completing a sale of their stock.  As the ruling continues:

X represents that X’s legal counsel discovered the Date3 amendments to X’s Articles of Incorporation that created two classes of stock, in connection with due diligence performed prior to the sale of X stock by A and B that occurred on Date6. Upon learning about this Date3 amendment, X’s Board of Directors amended X’s Articles of Incorporation on Date5 to reconstitute the class A and class B shares into a single class of stock with identical rights to distribution and liquidation proceeds, in order to rectify the ineffectiveness of X’s S corporation election.[4]

It is important to note that if, in fact, X had never been an S corporation, it owed C corporation taxes for the purported S years.  A buyer of the stock clearly would not want to take over a corporation with a potentially large tax bill due.  Thus, likely as a condition of closing the sale, the buyer insisted that the corporation get an IRS waiver on the issue.

Eventually, the problem was resolved and, as was noted in the ruling, the sale went through. The IRS held:

Based solely on the facts submitted and the representations made, we conclude that X’s S corporation election was ineffective on Date4 as a result of the second class of stock created by the Date3 amendment to X’s Articles of Incorporation. We conclude that this ineffectiveness was inadvertent within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as an S corporation beginning on Date4 and continuing thereafter, unless X’s S corporation election otherwise terminated under §1362(d) for other reasons.[5]

All is well, so this is not a big deal, correct?  Not so fast—a private letter ruling involves paying a not insignificant IRS user fee and a lot of professional time to get the ruling through the process.  As well, a sale the taxpayer thought was a done deal gets put on hold while waiting for a formal IRS decision (likely a number of months).

The taxpayer is likely not happy about the situation and will most likely believe that one or more professionals failed them in this case.  After all, why wasn’t this problem caught until a due diligence review was undertaken and someone read the Articles of Incorporation, as amended, and ran across the rather clear violation of the one class stock rule?  Presumably, no one had looked closely enough (or at all) when the S election was made, and that error continued each year when the return was prepared.

That unhappiness may translate to claims being made against counsel(s) and/or the CPA(s) for the costs of getting a ruling and the delay in closing the sale—and there is a reasonable chance the client’s claim will be successful in extracting funds from one or all professionals involved.

The discovery of issues during a due diligence review of a sale is a major reason why these rulings are sought by taxpayers.  So while it is potentially true, the IRS is unlikely to raise this issue on exam (though clearly they can do so), that doesn’t mean this is not a real problem that could bring very negative consequences to the professionals involved.

[1], August 30, 29, retrieved August 30, 2019

[2] Ibid, p. 2

[3] Ibid

[4] Ibid

[5] Ibid, p. 4