Cleaning IRS’ Clogged Pipes: Correcting S or QSUB Election Errors
December 12, 2022
A limited liability company or corporation that makes a S or QSUB election must comply with various strict requirements. One important requirement is that the entity must have one class of stock[1], i.e., each share of stock or membership interest must have the same “pro rata” rights.
An entity that operates as if there are two classes of stock will blow its S election, triggering an array of adverse ramifications. Fortunately, Section 1362(f) of the Internal Revenue Code provides some relief. A blown S election (or QSUB election, if applicable) can be remedied if (1) IRS determines that the circumstances resulting in an ineffective or blown S or QSUB election were inadvertent, (2) no later than a reasonable period of time after discovery of the issue steps were taken to remedy the problem, and (3) the entity and its owners agree to take the action required to remedy the problem.
On October 11, 2022, IRS published Rev. Proc. 2022-19, 2022-41 I.R.B. 282. The Revenue Procedure makes it easier for taxpayers to obtain relief. Prior to issuance of the Revenue Procedure, taxpayers had to apply for a Private Letter Ruling (“PLR”) requesting relief. However, seeking a PLR can be expensive and time-consuming. Taxpayers must pay a user fee to IRS ($38,000 in 2022) on top of professional fees incurred, and there’s no guaranty that IRS will provide the favorable guidance sought in the approximate nine-months it takes to obtain a ruling.
Yet, despite the cost and time, up to now taxpayers had little choice swamping IRS with requests. The new Revenue Procedure should dramatically reduce the number of PLR requests. Years from now Rev. Proc. 2022-19 may be likened to a safety value, now opened relieving IRS’ clogged pipes from what one imagines is a hefty workload on IRS’ already over-burdened staff.
B. Rev. Proc. 2022-19.
The Revenue Procedure addresses the following six situations that are now resolvable without filing a PLR:
(1) Non-Identical Governing Provisions. A problem for LLCs that make an S election arises where the entity adopts a multi-member operating agreement containing non-pro rata partnership tax allocation and distribution clauses referred to as “non-identical governing provisions”.
Examples of non-identical governing provisions include (a) any requirement to maintain capital accounts pursuant to the Section 704(b) rules that apply to partnerships and (b) providing exceptions for the otherwise pro-rata allocation of profits and losses or distributions on a pro rata basis, including allocating gains first to members having negative capital account balances upon dissolution or in other situations.
The Revenue Procedure provides corrective relief for taxpayers with operating agreements containing non-identical governing provisions as long as (a) the entity has not made, and for Federal income tax purposes is not deemed to have made, a disproportionate distribution to an applicable owner, (b) the entity timely filed all federal Form 1120-S tax returns for the applicable years, and (c) the entity takes the corrective action described immediately below before IRS discovers the non-identical governing provisions.
The required corrective action is three-fold:
(a) First, the entity must complete a “Corporate Governing Provision Statement”. The statement provides background information and representations from the company affirming that the eligibly requirements are met.
(b) Second, each “applicable shareholder” must sign a “Shareholder Statement” pursuant to which the owner makes certain representations specified in the Revenue Procedure. An applicable shareholder is defined as any owner beginning on the date on which the non-identical governing provisions were adopted and ending on the date the same were removed.
(c) Third, the entity must maintain the statements described above in (a) and (b) and the revised governing provisions for as long as such materials are relevant to the entity’s compliance with the applicable federal tax requirements.
If all three of the above requirements cannot be met, then the company may need to file for a PLR for relief. One potential problem is the potential for some former owners to not cooperate in signing a Shareholder Statement. A former owner also may not be available.
(2) Impact of Other Arrangements on Second Class of Stock Requirement. A ruling will not be required, and indeed IRS will not provide a PLR, with respect to whether certain agreements or arrangements (such as buy-sell agreements) could be viewed as creating a second class of stock. Prior to adoption of the Revenue Procedure, taxpayers feared that certain agreements or arrangements could have violated the S election requirements if the same altered the rights to distribution and liquidation proceeds. Rev. Proc. 2022-19 provides that “IRS will not treat any disproportionate distributions made by a corporation as violating the one class of stock requirement of § 1361(b)(1)(D) so long as the governing provisions of the corporation provide for identical distribution and liquidation rights.”
(3) Disproportionate Distributions. A ruling also will not be required to determine whether there has been a disproportionate distribution made by a corporation if the “governing provisions” of the corporation provide for identical distribution and liquidation rights. The key here may be identifying whether a policy or practice of making disproportionate distributions turns into a “governing provision” since, if true, then S corporate status could still be in jeopardy.
(4) Inadvertent Election Errors. An inadvertent error or omission made while electing S corporation status (via Form 2553) or QSUB (via Form 8869) will not invalidate the election, unless the error or omission is with respect to a shareholder consent, a selection of a permitted year, or an officer’s signature. Instead of applying for a PLR, taxpayers may now correct such errors through an explanatory letter to IRS.
(5) Missing Acceptance Letters. IRS will not issue a ruling regarding any missing S or QSUB election acceptance letter. Instead, taxpayers may obtain replacement letters by contacting the IRS directly: (a) for taxpayers, by calling, (800) 829-4533 and (b) for practitioners, by calling, (866) 860-4259.
(6) Filing Incorrect Tax Return. IRS will not issue a ruling regarding the impact on any S or QSUB election if the taxpayer has filed a federal tax return that is inconsistent with the election. Although the taxpayer should file the correct tax returns remedying the error, the Revenue Procedure indicates that filing the wrong return doesn’t impact the S or QSUB election.
C. Conclusion.
We anticipate that many taxpayers will take advantage of the easier method of obtaining relief provided by Rev. Proc. 2022-19. Some taxpayers are probably aware of S or QSUB election defects but were scared off by the onerous requirements for obtaining a PLR. Others aren’t even aware of the issue.
Failure to timely take advantage of the relief provisions could cause significant tax issues in the future. Third parties may also become concerned. Indeed, the issue often arises in due diligence of an M&A transaction potentially dooming, or at least complicating, an otherwise lucrative deal. Fortunately, the process is now easier for taxpayers that act sooner rather than waiting until it becomes too late.
We hope that this post provides some guidance, although please understand that the post does not represent a full discussion of the issues. Please contact our firm if you have any questions.
This post is intended as an introduction only to the topics addressed – it is not a full discussion of the issues presented. Let us know if you want to discuss the issues in this post in greater detail or if you have other questions.
DISCLAIMER. This post does not provide legal advice. We are providing it for general informational purposes only.
[1] Differences in voting requirements, i.e., Class A Voting Common and Class B Non-Voting Common where all economic terms remain the same are permitted.