S corporations offer advantageous tax benefits for businesses with simple capital structures. However, they are bound by rigorous requirements, presenting numerous chances for errors and the risk of losing S corporation status. In a recent development, the IRS introduced procedures to rectify certain missteps outlined in Revenue Procedure 2022-19, eliminating the necessity to undergo the time-consuming and costly process of obtaining a private letter ruling.
The IRS guidance identifies six potential problems (1), non-identical governing provisions; (2) principal purpose determinations relating to the single class of stock requirement; (3) disproportionate distributions; (4) errors/omissions on Form 2553 (S Corporation election) or Form 8869 (Qsub election); (5) missing S Corporation confirmation letters; and (6) filing returns inconsistent with S corporation status.
Of the six issues listed above, the most common is non-identical governing provisions that may create multiple classes of stock. One example could be an LLC that elects to be an S corporation but whose governing document contains language requiring liquidating distributions to be made in accordance with positive capital accounts, as opposed to a pro rata distribution as required for S corporations. Additionally, S corporations may issue stock options which may also raise questions about whether multiple classes of stock have been created.
Under Rev. Proc. 2022-19, S corporations can correct this misstep through self-help if certain requirements are met, e.g., the corporation has not made disproportionate distributions, it timely filed its tax returns, and it identified and corrected the problem prior to discovery by the IRS. The corporation simply needs to prepare a statement of facts, an explanation of how the nonidentical governing provision was discovered and corrected, and the actions taken to establish that the corporation acted reasonably and in good faith. This document is not sent to the IRS but kept in the corporate records in the case of audit.
A prospective buyer of such a business might contemplate avoiding unfavorable tax consequences resulting from invalid S status by mandating the seller to execute an F reorganization and subsequently acquiring the disregarded subsidiary. While this is a common and effective strategy, there could be lingering concerns about potential residual tax obligations associated with the disregarded entity's historical S corporation status. Although advantageous for the buyer, it's essential to note that this approach does not mitigate the risk for the S corporation shareholders. Consequently, this self-help mechanism could prove valuable for such shareholders. If a flaw in a corporation's S corporation status is identified, the self-help approach could serve as a valuable solution to consider.
Navigating the intricacies of maintaining S corporation status requires a keen understanding of tax regulations and potential pitfalls. Reach out to one Kelleher + Holland, LLC’s corporate attorney who can assess your situation, provide tailored advice, and guide you through the necessary steps to ensure compliance.
