S corporation status retained despite disproportionate distributions
IRS rules that errors did not compromise tax status
TAX ALERT |
The IRS recently ruled (PLR 201633017) that a company’s subchapter S status did not terminate as a consequence of disproportionate distributions resulting from incorrect ownership percentage information. The IRS further ruled that composite tax payments that the company treated as interest-free loans, some of which had not been repaid, did not cause the company’s subchapter S status to terminate.
Subchapter S corporations are typically cautious about undertaking actions that might compromise the company’s qualification under subchapter S. For example, S corporations often have procedures in place that ensure that a disqualified individual or entity cannot become a shareholder. Similarly, S corporations typically monitor their shareholder distributions to ensure that they are proportionate to stock ownership to avoid the potential for creating a second class of stock.
The taxpayer in question had hired a new accounting firm, who discovered that the company had been making disproportionate distributions as a consequence of using incorrect ownership information. The accounting firm also noted the company’s practice of treating composite payments as loans, and its failure to seek repayment of those amounts from its shareholders. After the accounting firm identified these issues, the company made corrective distributions and modified its policy to no longer treat the payment of composite taxes as loans.
The IRS concluded that the company’s subchapter S status did not terminate as a consequence of the disproportionate and corrective distributions. The IRS noted that (a) the company’s governing documents provided for identical distribution and liquidation rights, and (b) the company represented that the disproportionate distributions were not made with a principle purpose of circumventing the single class of stock requirement.
It is not surprising that the IRS concluded that the taxpayer’s subchapter S status should be retained. However, it is noteworthy that the IRS concluded that the company’s status did not terminate. In prior rulings with similar facts, the IRS has typically concluded that a company’s status may have terminated. The distinction would be noteworthy because taxpayers whose status has (or may have) terminated, would often need to seek relief from the possible inadvertent termination via a letter ruling request. That would not be necessary, however, if the IRS were to conclude that such inadvertent errors do not terminate an entity’s subchapter S status.
It is unclear whether this conclusion is an aberration or part of a trend. It is also important for taxpayers to recognize that private letter rulings only apply to the taxpayer seeking the ruling and cannot be cited as precedent by other taxpayers. Nonetheless, the ruling is noteworthy and taxpayers should monitor whether this may suggest that the IRS is taking a more forgiving approach to foot faults with S corporation distributions.