United States

Final regulations address issues for former S corporations

The guidance provides some good news, some bad news

TAX ALERT  | 

The IRS released final regulations that provide some good news and some bad news for former S corporations that switched to C corporation status following enactment in 2017 of the Tax Cuts and Jobs Act (TCJA). See our prior alert regarding the proposed regulations released in November 2019. 

The good news

The regulations clarify that former S corporations that experienced an ownership change after the effective date of their revocation, but prior to the filing of that revocation (i.e., a retroactive revocation), can still qualify as eligible terminated S corporations (ETSCs) and thereby benefit from some of the enhanced tax-free distribution provisions enacted as part of TCJA. The proposed regulations would have denied ETSC status to former S corporations in this situation.

And the bad news

In certain cases, cash-basis S corporations that made the switch to C corporation status were required to concurrently switch to the accrual method of accounting. That change would often trigger an income pickup. To ease that transition, TCJA included a provision that allowed ETSCs to take such adjustments into account over an extended six-year window (generally by way of automatic method change procedures). 

Taxpayers quickly recognized, however, that former qualified subchapter S subsidiaries (QSubs) likely would not qualify for this six-year spread. This issue was particularly acute for S corporations owning QSubs that could not avoid this issue by converting to a single-member LLC. This was a real issue in the banking industry. 

Following the release of the proposed regulations, numerous taxpayers and practitioners submitted comments identifying this issue and seeking relief. The preamble to the final regulations discusses this issue and taxpayers’ concerns at length. Ultimately, the IRS concluded that taxpayers’ concerns were well-founded, agreeing that former QSubs cannot take advantage of the six-year spread. Unfortunately, the IRS also concluded that it had no authority to provide the relief that taxpayers sought. As such, the IRS has clearly articulated its position that former QSubs do not qualify for the six-year income spread, meaning they often will be required to recognize these income pickups in the year following the parent’s revocation of its subchapter S status.

Final regulations closely mirror proposed regulations

The final regulations otherwise leave largely unchanged the guidance outlined in the proposed regulations. In most cases, that guidance is taxpayer friendly, and will make it easier for former S corporations to distribute their prior accumulated S corporation earnings on a tax-free basis.

These regulations are effective for tax year beginning after the date of their publication in the Federal Register, although taxpayers can rely on the guidance in its entirety for years prior to their publication.

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