Executive summary: S corporation taxpayer assistance procedures
S corporations and their shareholders stand to benefit from taxpayer assistance procedures that allow them to quickly resolve several issues with S corporation elections frequently encountered during due diligence. The IRS provided the simplified procedures in Rev. Proc. 2022-19 on Oct. 11.
S corporation due diligence complexities
S corporations are subject to a litany of rules and restrictions, the violation of which can often result in catastrophic consequences—such as a loss of S corporation status. These issues often are not discovered until an S corporation goes through the due diligence process. Discovery of a foot-fault or misstep with respect to any of the stringent rules can sometimes require the expensive and time-consuming process of obtaining a private letter ruling, or PLR, to correct.
One of the most common issues in S corporation due diligence is proving that the company has a valid S election or Qualified Subchapter S Subsidiary election. The IRS has potentially made this process simpler in six different areas by recently issuing Rev. Proc. 2022-19, which provides simplified methods for relief without the need to request a PLR.
Of particular significance is the new administrative relief provision allowing S corporations and their shareholders to retroactively validate or preserve an S election that was either invalid or terminated as a result of a second class of stock caused by “non-identical governing provisions.”
Non-identical governing provisions historically have been a major issue for limited liability companies electing S status. Certain boilerplate LLC agreements can contain language that would provide for different liquidation or distribution rights, such as a provision requiring liquidating distributions to be made in accordance with positive capital account balances. Prior to the issuance of Rev. Proc. 2022-19, correcting such an issue would require the company to go through the process of obtaining a PLR.
Generally, to be eligible for retroactive relief for “non-identical governing provisions,” the following requirements must be met:
- Existence of rights: The entity has or had one or more non-identical governing provisions
- Identical timing and amount: All distributions to applicable shareholders, actual or deemed to occur, must be identical in timing and amount.
- An interesting aspect is that a differencing in timing but not amount would appear to disqualify taxpayers from qualifying for relief under these simplified procedures; however, it may not actually create a second class of stock for tax purposes. A common example here would be an S corporation that makes a final distribution each year to equalize shareholders.
- These provisions also may not hold the key to other common problems encountered around excessive compensation or utilization of company employees for individual purposes.
- Timely filing: The corporation filed a return on Form 1120-S, before the original due date without extension plus six months, for each taxable year during the testing period. The testing period runs from the year in which the first non-identical governing provision was adopted through the taxable year immediately preceding the year in which the corporation made a request for corrective relief; and
- First to find: The taxpayer must fulfill the requirements of the Rev. Proc. prior to discovery of the non-identical governing provision by the IRS.
If the S corporation is eligible for relief the corporation will be required to complete a “Corporate Governing Provision Statement,” and the shareholders will be required to complete a “Shareholder Statement.” These statements provide, among other things, an explanation of each non-identical governing provision adopted, how it was discovered, and the corrective action taken.
Other simplified procedures
The revenue procedure (Rev. Proc). goes on to provide “Taxpayer Assistance Procedures For Addressing Or Correcting” the five other issues identified in the revenue procedure, as well as detailing whether the IRS will rule (or will ordinarily rule) on the issue. Specifically:
- Agreements and Arrangements with No Principal Purpose to Circumvent One Class of Stock Requirement - Examples include buy-sell agreements, transferability agreements, redemption agreements, debts agreements, etc
- Governing Provisions That Provide for Identical Distribution and Liquidation Rights – If the governing instrument requires equivalency but actual distributions are different as to amount or timing the S election is not terminated
- Procedures for Addressing Missing Shareholder Consents, Errors with Regard to a Permitted Year, Missing Officer's Signature, and Other Inadvertent Errors and Omissions
- Procedures for Verifying S Elections or QSub Elections
- Procedures for Addressing a Federal Income Tax Return Filing Inconsistent with an S Election or a QSub Election.
These procedures, as well as a transition rule for pending PLRs, are all contained in Rev. Proc. 2022-19. There is hope that these simplified procedures will allow for speed and ease in due diligence and transactions, as well as reduce burdens on S corporations, their shareholders and tax professionals.