Recommendations submitted by the American Bar Association Section of Taxation (ABA Tax Section) suggest the Department of the Treasury and the IRS should expand the eligibility requirements for simplified corrective relief under Rev. Proc. 2022-19 to include what many refer to as “double fault” situations — those in which entities electing S corporation status have adopted “non-identical governing provisions” and made disproportionate distributions that inadvertently cause their S election to be invalid or to terminate. The recommendations are part of a comment letter submitted by the ABA Tax Section on October 17, 2024.
Rev. Proc. 2022-19 Simplified Corrective Relief
Rev. Proc. 2022-19 provides corrective relief for common situations that jeopardize the validity of S elections, including a reminder that Treasury regulations provide that issuing a disproportionate distribution does not create a second class of stock (and, therefore, does not jeopardize S status) as long as the corporation has “identical governing provisions,” meaning the entity’s governing provisions confer identical rights to distribution and liquidation proceeds with respect to all outstanding shares.
When an electing S corporation has non-identical governing provisions (and, thus, does not satisfy the one-class-of-stock requirement), Rev. Proc. 2022-19 provides a simplified procedure for preserving S status through retroactive corrective relief. Under the simplified procedure, the IRS will not invalidate or terminate an entity’s S election as a result of having a non-identical governing provision, provided:
- The electing corporation has not made and is not deemed to have made any disproportionate distributions;
- The corporation has timely filed its federal S corporation tax return (Form 1120-S) for all applicable taxable years; and
- Before the IRS discovers any non-identical governing provision, the corporation seeks corrective relief in accordance with the rules and procedures contained in Rev. Proc. 2022-19.
Corporations with non-identical governing provisions that do not meet all of the requirements to use the simplified procedure may obtain corrective relief only through seeking a private letter ruling (PLR) from the IRS, the process for which can be extremely costly and time-consuming for taxpayers.
Comment Letter Recommendation
In its comment letter, the ABA Tax Section recommends Treasury and the IRS expand the eligibility requirements for simplified corrective relief under Rev. Proc. 2022-19 to include disproportionate distributions made (or deemed made) by a corporation with non-identical governing provisions, provided the disproportionate distributions were not made pursuant to the non-identical provisions.
Notably, the recommendation would address frequently encountered situations in which entities that made S elections later discover they have inadvertently adopted a non-identical governing provision, and, after amending the agreement to remove the non-identical provision, have issued both a disproportionate distribution and true-up distribution in the subsequent taxable year. Based on the existing guidance, the simplified procedure outlined in Rev. Proc. 2022-19 is not available. In this situation, if the IRS asserts the entity’s S status was never valid or that it terminated, even inadvertently, the only way the entity can preserve its S election is to seek a PLR. However, should the IRS adopt the ABA Tax Section’s recommendations, the entity would be able to use the simplified correction procedure contained in Rev. Proc. 2022-19 to preserve its S election.
BDO Insights
The ABA Tax Section’s comment letter comes approximately two years after Rev. Proc. 2022-19 was issued and follows similar comments from the AICPA in March 2023. Although the AICPA’s comments were submitted some time ago, Treasury and the IRS have yet to issue recommended guidance that would remedy situations frequently encountered by S corporations that could inadvertently cause their S elections to be invalid or to terminate, many of which occur due to a lack of resources of small businesses and start-ups seeking S status. The recommended guidance would also address recurring issues affecting S corporation due diligence targets whose only current option to guarantee their S status for prospective buyers is a costly and time-consuming PLR.
How BDO Can Help
BDO’s Corporate Tax Services professionals can help S corporations and their shareholders identify issues that could jeopardize their S status, determine options for correcting potentially invalid or terminated S elections, prepare documentation to comply with Rev. Proc. 2022-19 corrective relief, and/or prepare and submit PLR requests. Our professionals can also help S corporation targets prepare for due diligence related to a potential sale and assist potential buyers in the due diligence process.
Please visit BDO’s Federal Tax Services page for more information on how BDO can help.