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.

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Boilerplate Provision in LLC Operating Agreement Found to Terminate S Election

Under the check the box regulations, an LLC may elect to be an S corporation.  But it is important to remember that the LLC must meet all of the requirements to be treated as an S corporation during its life, which includes the single class of stock rule.  PLR 201918004 details a case where an LLC was forced to ask the IRS for relief from inadvertent termination of its S status when a review of the operating agreement found that the agreement provided for the potential for a disproportionate distribution.

IRC §1362(b)(1)(D) provides that one of the conditions for S status is that the corporation does not have more than one class of stock outstanding.  However, the “class of stock” is not based on state law rules for what makes for different classes of stock.  Rather, Reg. §1.1362-1(l)(1) creates a federal S corporation test for what constitutes the existence of only a single class of stock:

(1) General rule. A corporation that has more than one class of stock does not qualify as a small business corporation. Except as provided in paragraph (l)(4) of this section (relating to instruments, obligations, or arrangements treated as a second class of stock), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.

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Proposed Regulations Issued for ESBTs with NRA Potential Current Beneficiary Subject to Grantor Trust Rules

The IRS has moved to plug a potential loophole created when Congress changed the law in the Tax Cuts and Jobs Act (TCJA) to allow an electing small business trust (ESBT) to have a nonresident alien (NRA) potential current beneficiary (PCB).  In proposed regulations REG-117062-18 the IRS provides that if such an NRA would be treated as the owner of trust corpus under the grantor trust rules for such a trust, the grantor will not be treated as the owner of the S corporation portion of the ESBT.

In the preamble to the proposed regulations, the IRS points out that the committee reports related to the TCJA had stated that allowing NRAs to be PCBs of ESBTs did not pose a risk that the S corporation income would not be subject to U.S. tax, since tax is imposed on the trust and not the beneficiary for S corporation income when shares are held by an ESBT.

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Structure Used By Shareholder to Hold S Shares Terminated S Status Instantly Upon Shareholder's Death

In Private Letter Ruling 201730002 we find a situation where a taxpayer’s death instantly terminated the S corporation in which he owned a 100% interest.  The structure he created to hold the S corporation stock set up a situation in which the S election’s validity continued only so long as the shareholder remained alive.

Image copyright carmenbobo / 123RF Stock Photo

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Acquiring Corporation Forced to Seek IRS Relief for Failure to Notice That QSST Elections for Trusts Holding Stock of Acquired Company Were Not Valid for Its Stock

Although we don’t for sure how the issue managed to slip through the cracks, many advisers will have sympathy for the situation that gave rise to the need to request late QSST election relief and treatment of termination of S status as inadvertent in PLR 201618003

In the situation in question an existing S corporation had among its shareholders two trusts, each of which had timely an election to be a qualifying Subchapter S trust (QSST)under IRC §1361(d)(2).  

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Agreement on Application of Trust Terms Found to Allow Trust to Be Treated as QSST

Qualified Subchapter S Trusts (QSSTs) are one of the limited set of trusts that are eligible S corporation shareholders upon the election of the beneficiary to treat the trust in this manner.  However, such trusts must have terms that conform to requirements imposed by the law in order for the trust to be eligible, upon the beneficiary’s election, to be treated as such a trust.

In PLRs 201614002 and 201614003 the taxpayers were asking the IRS whether a binding, nonjudicial settlement under state law regarding the trust’s language could be used to solve what otherwise appeared to be problems with the terms of trusts for which an S election was desired.

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Agreement on How to Distribute Liquidation Proceeds Created Second Class of Stock

One of the major disadvantages of an S corporation involves the rather strict rules that must be followed to maintain it status.  One of the key rules involves the one class of stock requirement found at IRC §1361(b)(1)(D).  If an S corporation has outstanding more than one class of stock, as defined in Reg. §1.1361-1(l)(1), its S status is terminated as of the first day that second class of stock is found to exist.

In PLR 201605002 the taxpayers found that what they wanted to do ran afoul of these rules. While the taxpayers were able to persuade the National Office that this was inadvertent and they received the right to fix the issue and still be considered an S corporation, that only happened after the taxpayers went to the expense of obtaining their own private letter ruling.

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