S corporations get reprieve under debt-equity regulations
Treasury finalizes section 385 regulations—exempts S corporations
TAX ALERT |
The S corporation community is responding favorably to the release on Oct. 13 of the much anticipated earnings-stripping regulations. These final and temporary regulations make several significant changes to proposed regulations released in April, most notably the decision to exclude S corporations from the ‘expanded group.’ This change effectively exempts S corporations from these rules.
The earnings-stripping regulations were drafted in large part to help address Treasury’s concerns regarding certain base-erosion practices. In particular, Treasury was concerned that commonly-owned entities, particularly in a cross-border context, could structure related party financings as debt in order to strip earnings out of the United States through related interest deductions. In an effort to help curb this practice, Treasury released proposed regulations in April that would have recharacterized certain related party debt as equity in certain circumstances.
The concern for S corporations
Although the proposed regulations were largely meant to address base-erosion practices, they applied to taxpayers without regard to whether they were domestic or foreign. Therefore, their impact extended to taxpayers that had no interest in base-erosion practices. In addition, the proposed regulations gave the IRS authority to bifurcate debt in certain circumstances—treating it as part debt and part equity—and also outlined specific documentation requirements that, if not followed, could result in financings being characterized as equity.
For S corporations, recharacterization of debt into equity can be catastrophic for two reasons. First, if the debt holder is not a qualifying S corporation shareholder, recharacterization would terminate the company’s S election. Second, recharacterization of debt into equity would likely result in the company being treated as having more than one class of stock, which would also terminate the company’s S election.
For these reasons, the S corporation community had been requesting relief, either through some type of assurance that a company’s subchapter S status would not be compromised as a consequence of these rules or through outright exemption from the rules.
Somewhat surprisingly, Treasury opted for the latter in the final and temporary regulations—outright exemption from the rules. S corporations are not considered part of the expanded group to which these rules apply, and as such are effectively exempted from the rules. This is welcome news to entities that, despite engaging in none of the activities being targeted, might have faced significant uncertainty regarding whether related party financings might jeopardize their subchapter S status. These final and temporary regulations should alleviate those concerns.
For additional information on the final and temporary section 385 regulations, please read our alert, Final debt-equity regulations released.