Middle-market buyers of owner-operated companies often encounter transactions involving small business corporations (S corporations). Although S corporations provide valuable pass-through taxation benefits to buyers, failing to carefully plan for and monitor the S corporation requirements can cause the S corporation to be disqualified for pass-through status or to unintentionally change its pass-through status. On October 11, the IRS released Rev. Proc. 2022-19, which provides important clarification and simplified procedures for resolving certain S corporation and Qualified Subchapter S (QSub) election issues that may surface during mergers and acquisitions (M&As). It also lists issues on which the IRS will not provide rulings. In this article, we briefly explain the new guidance and what it means for taxpayers.
The need for guidance
Successfully making and maintaining a valid S corporation and QSub (Subchapter S) election can be challenging for taxpayers because the entity must meet a strict list of requirements and maintain continuous compliance with those requirements for the election to remain valid. Due to the complexity of these rules, invalid Subchapter S elections are often discovered during the acquisition process. Even seemingly minor noncompliance with the rules can jeopardize the status of the entity’s Subchapter S election. If Subchapter S election issues prevent the entity from having pass-through status, it can cause additional C corporation taxes assessed at the entity level. Invalid Subchapter S elections often result in closing delays, excessive escrow requirements, additional indemnity provisions, and even exclusions from representations and warranties insurance coverage. These consequences can be frustrating to the parties and even derail the transaction.
Requesting a private letter ruling, which is a costly and time-consuming endeavor, is often the only way to correct an invalid Subchapter S election. Accordingly, many taxpayers and practitioners have requested guidance from the IRS on the impact that minor noncompliance may have on Subchapter S elections, as well as simplified processes for correcting certain deficiencies. In response, the IRS issued Rev. Proc. 2022-19 on October 11. This new guidance clarifies existing rules and provides additional guidance and simplified procedures for obtaining relief for many common Subchapter S issues, without forcing taxpayers to incur the expense and delays associated with the pursuit of a private letter ruling. Rev. Proc. 2022-19 provides procedures that, if specific requirements are satisfied, would retroactively cure certain common deficiencies in Subchapter S status.
Subchapter S issues covered by Rev. Proc. 2022-19
Rev. Proc. 2022-19 provides clarification for common Subchapter S election issues and provides simplified relief procedures if specific requirements are met. The Revenue Procedure also excludes certain S corporation status issues from being resolved through private letter rulings. Taxpayers must carefully analyze their unique facts and circumstances, and when the requirements for simplified relief under Rev. Proc. 2022-19 are not met, a private letter ruling may remain the only path for taxpayers to resolve Subchapter S election issues. Rev. Proc. 2022-19 addresses each of the six categories below, all of which present common scenarios that raise concerns about the validity of Subchapter S elections.
- Contracts creating a second class of stock with no principal purpose to circumvent the one class of stock requirement: Common examples of contracts that create a second class of stock include commercial contracts, buy-sell agreements among shareholders, and redemption agreements.
- Disproportionate distributions despite governing provisions providing for identical distribution and liquidation rights: Cash or property may be distributed to shareholders in a manner that’s disproportionate to the shareholders’ relative ownership interests in the entity.
- Inadvertent errors or omissions on the Subchapter S election: Errors and omissions on the Form 2553, Election by a Small Business Corporation, or Form 8869, Qualified Subchapter S Subsidiary Election, may include minor defects like missing shareholder consents, officer signatures, or other required information.
- Missing or misplaced Subchapter S election acceptance letters: IRS acceptance letters may be lost, never received by the taxpayer, or are otherwise unable to be produced often cause purchasers to question whether the IRS ever recognized that the entity had Subchapter S status.
- Inconsistent federal income tax return: This may include an S corporation that files a federal income tax return on a form different than the required Form 1120S or takes positions contrary to a valid Subchapter S status.
- Nonidentical governing provisions with respect to stock rights: An example includes LLCs with Subchapter S elections that have provisions in their operating agreement allowing distributions to be made in accordance with positive economic capital account balances instead of the required proportionate ownership percentages.
Although Rev. Proc. 2022-19 addresses errors and omissions on the Form 2553 and Form 8869, it’s silent on how taxpayers should address situations where the Form 2553 or Form 8869 is unable to be produced. The Revenue Procedure notes that the Subchapter S election acceptance letters are merely administrative acknowledgments of an effective election, which suggests that the Form 2553 and Form 8869, on which the Subchapter S elections are made, are particularly important for buyers to review.
How does Rev. Proc. 2022-19 impact the acquisition of a company with a Subchapter S election?
Before Rev. Proc. 2022-19, Subchapter S election issues were frequently resolved through short-term deal terms, including indemnity provisions, escrow account requirements, or holdbacks, or structuring the deal as a purchase of assets instead of stock. Such measures were often employed due to the practical inability to pursue relief through private letter rulings. Rev. Proc. 2022-19 clarifies how many of the more common Subchapter S election issues can be resolved without the need to obtain a private letter ruling. Since pursuing private letter rulings was often impractical in the context of a transaction, Rev. Proc. 2022-19 may eliminate significant uncertainty for certain buyers, depending on their unique circumstances and the type of Subchapter S election issues involved in the transaction. For these taxpayers, Rev. Proc. 2022-19 may allow them to resolve Subchapter S election issues in a much quicker, less expensive manner.
In light of the issuance of Rev. Proc. 2022-19, taxpayers should remember that for common Subchapter S election issues, streamlined procedures are available to correct errors or file relief requests before closing occurs. Both buyers and sellers benefit as a result of their ability to close transactions quicker and more economically, and without including unnecessary deal terms, escrow agreements, indemnity provisions, and additional representations and warranty insurance coverage. Buyers can benefit because they can still acquire the company with the assurance that Subchapter S elections will be deemed valid.
Final thoughts
Depending on the circumstances of the transaction and the Subchapter S election issues involved, Rev. Proc. 2022-19 presents opportunities for parties involved in the acquisition of an S corporation to resolve certain Subchapter S election issues more efficiently and economically than previously allowed. If you have questions about how these new provisions may impact your transactions, our experts can help.
