S corporations provide valuable tax advantages for businesses with simple capital structures. Unfortunately, they are subject to stringent requirements creating multiple opportunities for missteps and potential loss of S corporation status. Recently, in. Rev. Proc. 2022-19, the IRS provided methods for addressing some such missteps, without the need to incur the time and expense to seek 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 those six issues, probably the most common is non-identical governing provisions that may create multiple classes of stock. An example is 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.
While a buyer of such a business may think “I can avoid any adverse tax result from invalid S status by requiring the seller to conduct an F reorganization and then purchasing the disregarded subsidiary.“ This is a common and effective strategy, although there may be some lingering concern over potential residual tax liability of the disregarded entity as the historic S corporation. And while this is a great strategy for a buyer, it does not reduce the risk to the S corporation shareholders. Accordingly, this self-help mechanism could be valuable to such shareholders.
Bottom Line: If an infirmity in a corporation’s S corporation status is discovered, the self-help method described above may be a valuable remedy to keep in mind.
“You only live once, but if you do it right, once is enough.” – Mae West