Comment Letter Urges IRS to Clarify Treatment of S Corporation State Law Conversions

Comments submitted on behalf of the American Bar Association Section of Taxation (ABA tax section) in a letter dated July 2, 2024, suggest the IRS should supplement or expand its 2008 guidance on F reorganizations involving S corporations and qualified subchapter S subsidiaries (QSubs) to include consequences of an F reorganization accomplished by state law conversion to a limited liability company (LLC). The additional guidance is needed to address uncertainties in planning and other transactions commonly used by S corporations and their shareholders.

Summary of 2008 IRS Guidance

Rev. Rul. 2008-18 provides guidance on whether, in an F reorganization involving an S corporation, the historic Subchapter S election and employer identification number (EIN) continue for the reorganized (surviving) entity. The revenue ruling addresses two specific transactions, each of which meet the requirements of an F reorganization under Section 368(a)(1)(F): 

Situation 1: The shareholder of an S corporation contributes all of the S corporation stock to a newly formed corporation (Newco). A valid QSub election is made for the contributed corporation, causing it to be a disregarded entity treated as a division of Newco.

Situation 2: In a plan of reorganization, an S corporation creates a newly formed corporation (Newco), which also creates a newly formed corporation (Mergeco). Mergeco merges into the S corporation, with the S corporation’s shareholder receiving the stock of Newco. A valid QSub election is made for the S corporation (now a subsidiary of Newco), causing it to be a disregarded entity treated as a division of Newco.

The revenue ruling concludes that under these two fact patterns, the historic S corporation election does not terminate but continues for the corporation that is the survivor of the reorganization (Newco). However, Newco must obtain a new EIN.

Uncertainties Surrounding S Corporation State Law Conversions

Rev. Rul. 2008-18 does not address the continuation of an S corporation election or EIN when the S corporation undergoes an F reorganization (with or without a QSub election made for the contributed corporation) through a state law “conversion” to an LLC. Whether a QSub election is necessary in a state law conversion is also unclear, since – assuming no entity classification election is made to treat the LLC as a regarded corporation – the surviving LLC would be disregarded under Treas. Reg. §301.7701-3. If a QSub election is required by the IRS, the election would not be valid if made after the corporation converts to an LLC.

In addition, any delay by the state in processing the conversion raises questions about whether the subsidiary loses its S corporation status in the reorganization transaction and, therefore, reverts to C corporation status for a period of time.  If so, the corporation could be subject to built-in gains tax under Section 1374.

Comment Letter Recommendations

To address the uncertainties for S corporations surrounding F reorganizations accomplished by state law conversions, the ABA tax section in its comment letter recommends the IRS supplement or expand Rev. Rul. 2008-18 to address a third situation: 

Situation 3: The shareholder of an S corporation contributes all of the S corporation stock to a newly formed corporation (Newco). The contributed corporation is converted under state law from a corporation to an LLC for which no entity classification election is made. In addition, no QSub election is made for the contributed corporation. 

The comment letter concludes that this fact pattern should have the following consequences:

• The historic S corporation election would not terminate but would continue for the newly formed corporation as the survivor of the reorganization.
• The LLC (formerly the S corporation) would retain its historic EIN. 
• The newly formed survivor corporation would need to obtain a new EIN.
• The LLC would be respected as a disregarded entity, eliminating the need to make a QSub election, and would not be treated as a C corporation for federal income tax purposes for any period of time during the reorganization transaction, including for purposes of taxing built-in gains under Section 1374.
  
  

Should the IRS not accept the comment letter’s suggestions to update or supplement their 2008 guidance, the ABA tax section alternatively recommends the IRS provide a streamlined procedure for curing a timely but invalid QSub election. This would be similar to Rev. Proc. 2013-30, where an election has been deemed invalid because the subsidiary did not meet the domestic corporation requirement at the time the election was made.