United States

IRS signals change to S corporation ruling policy

IRS will no longer rule on disproportionate distributions

TAX ALERT  | 

S corporations will not be able to look to the IRS private letter ruling process anymore for assurance that their subchapter S status will be unaffected by certain technical missteps. The IRS is signaling, however, that the assurance they have provided in the past might have been unnecessary.

Background

Subchapter S corporations are subject to numerous restrictions. Violating those restrictions can have serious consequences, including potential termination of the company’s subchapter S status. One of the most notable restrictions is the requirement that the company only have one class of stock, which generally means that the company’s shares must all have equal rights to distribution and liquidation proceeds.

It is not unusual, however, for an S corporation to violate this rule—often inadvertently. For example, taxpayers often have concerns that disproportionate distributions (i.e., distributions that are not in proportion to share ownership) might be viewed as creating a second class of stock. Although these types of missteps might seem innocuous, taxpayers (or potential acquirers) often are concerned that they might jeopardize the company’s subchapter S status. As a consequence, companies that become aware of these types of issues sometimes seek a ruling from the IRS to gain assurance that their mistake does not jeopardize the company’s status.  

Announcement

An IRS Chief Counsel representative recently announced that the IRS will no longer entertain ruling requests involving disproportionate distributions. In addition, the representative stated that the IRS will not rule on whether certain instruments and agreements, such as employment agreements, debt agreements, etc., might be construed to create a second class of stock. This announcement clarifies earlier rumblings from the IRS that they were considering restricting the areas in which it would rule.  

Takeaway

Although this news might seem concerning, it may instead be a signal from the IRS that a common foot fault (disproportionate distributions) do not jeopardize a company’s subchapter S status. The regulations clearly state that a company only has one class of stock as long as its governing documents so provide. Nonetheless, taxpayers have often sought assurance from the IRS ruling process out of an abundance of caution. The IRS is now indicating that those rulings likely were unnecessary and will not be entertained in the future.

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