Overview
Many closely held businesses operate through entities classified as “S corporations,” an elective federal income tax regime that combines elements of corporate and partnership taxation. Among other reasons, S corporations are frequently viewed as tax-favorable vehicles because their flow-through nature allows for a single layer of federal income tax.
Electing and maintaining S corporation status requires adherence to strict requirements. During (or sometimes prior to) a sales process, such requirements are frequently scrutinized as part of tax diligence. For S corporations formed as limited liability companies (LLCs), a recurring pre-closing deal issue is the discovery of an inadvertent creation of a prohibited “second class of stock” caused by provisions in the target S corporation’s LLC operating agreement. This second class of stock invalidates the target’s S corporation election (S Election) from the date the offending provisions in its LLC operating agreement were adopted – in some cases, from the date the LLC was formed.
In October 2022, the Internal Revenue Service (IRS) issued Revenue Procedure 2022-19 to provide a mechanism to resolve certain “foot faults” that made an S Election invalid without the need to seek a private letter ruling (PLR) from the IRS, which adds time, cost, complexity, and uncertainty to a transaction.
In Depth
S CORPORATIONS GENERALLY
A qualifying domestic corporation (or an eligible entity that elects to be treated as such) may elect to be treated as an S corporation for federal income tax purposes. Like partnerships, an S corporation’s items of income, gain, losses, deductions, and credits flow through to its owners. An S corporation files an annual federal income tax return and issues a Schedule K-1 to each of its shareholders to report each shareholder’s proportionate share of the S corporation’s tax items.
To elect and maintain S corporation status, an entity must (1) be a domestic corporation (or an eligible entity electing to be treated as such), (2) have only allowable shareholders, (3) have no more than 100 shareholders, (4) have only one class of stock, and (5) not be an “ineligible” corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations). Permitted shareholders include individuals, certain trusts, and estates while prohibited shareholders include partnerships, corporations, and nonresident aliens.
Generally, a corporation is treated as having one class of stock if all outstanding shares of the corporation’s stock grant identical rights to distribution and liquidation proceeds. A purported S Election filed by an entity when it has a “second class of stock” is invalid. Certain agreements, such as buy-sell agreements among shareholders, transfer restriction agreements, and stock redemption agreements, generally do not create a “second class of stock,” provided that a principal purpose for such agreement is not to circumvent the “one class of stock” requirement.
VALIDITY OF AN S ELECTION
Confirming the validity of a target LLC’s S Election during diligence is crucial to structuring a transaction. For example, if a deal requires the target S corporation to undergo a pre-closing “F” reorganization and it is later determined that its S Election was invalid, then the purchaser may bear the cost of the target’s historic unpaid corporate level tax. Similarly, if instead the transaction is structured as a purchase of the target LLC’s “stock” with the seller and purchaser agreeing to make a Section 336(e) election (to treat the purchase of “stock” as an asset sale resulting in a basis step-up in the LLC’s assets), such election will be invalid if the target LLC’s S Election is invalid.
THE BOILERPLATE OPERATING AGREEMENT
Many multimember LLCs are treated as partnerships for federal income tax purposes and for that reason, their operating agreements often contain, among other provisions, a myriad of boilerplate citations to partnership tax provisions of the Internal Revenue Code and Treasury Regulations, priority operating distribution waterfalls, and provisions requiring liquidating distributions to be made based on capital accounts or on a priority liquidating distribution waterfall.
If such provisions are followed as set forth in the applicable operating agreement, disproportionate distributions may be made to the LLC’s members, thereby resulting in the LLC having a second class of stock. The IRS takes the position that the mere existence of such provisions (i.e., “non-identical governing provisions”) has the effect of invalidating an S Election, even if such provisions are not followed and all distributions (if any) are or were made proportionally to the LLC’s members. In Revenue Procedure 2022-19, the IRS sought to provide relief for situations, such as the latter scenario, so that an entity that otherwise made a valid S Election would not be required to pursue a PLR pursuant to Code Section 1362(f) for retroactive relief.
REVENUE PROCEDURE 2022-19
Revenue Procedure 2022-19 allows S corporations and their shareholders to retroactively resolve frequently encountered issues with certainty and without needing to pursue a PLR. The six areas identified in Revenue Procedure 2022-19 that are resolvable without obtaining a PLR are:
- One class of stock requirement and governing provisions, including “principal purpose” conditions
- Disproportionate distributions
- Certain inadvertent errors or omissions on IRS Form 2553 or IRS Form 8869
- A missing administrative acceptance letter for S Election or qualified subchapter S subsidiary (QSub) election
- A federal income tax return filing inconsistent with an S Election or a QSub election
- “[N]on-identical governing provisions.”
Provisions in a target LLC S corporation’s operating agreement that have the effect of creating more than one class of stock (e.g., partnership tax provisions) are referred to as “non-identical governing provisions” and result in the LLC’s S Election being invalid (even if the LLC never made a disproportionate distribution). Revenue Procedure 2022-19 provides retroactive relief for such situation provided the LLC meets the following conditions:
- The LLC has or had one or more “non-identical governing provisions.”
- The LLC has not made (or deemed to have made) disproportionate distributions.
- The LLC has consistently and timely filed IRS Form 1120-S (S. Income Tax Return for an S Corporation) for each taxable year of the LLC beginning with the tax year in which the first “non-identical governing provision” was adopted and through the tax year immediately preceding the tax year in which the LLC made a request for corrective relief.
- The IRS has not yet discovered any “non-identical governing provision.”
If the LLC satisfies those four conditions, then Revenue Procedure 2022-19 sets forth a process for the LLC to obtain relief that does not require any filing with the IRS. Specifically, the LLC must prepare a statement, signed under penalties of perjury by a person authorized to sign the LLC’s tax return (i.e., Form 1120-S), that (1) details the “non-identical governing provision(s),” (2) describes each corrective action taken to correct or remove the “non-identical governing provisions,” and (3) includes a list of all persons who have been members (shareholders) since the “non-identical governing provision(s)” took effect until the LLC adopted the new “identical governing provision(s).” Revenue Procedure 2022-19 requires the LLC to retain such statement and other applicable documentation in its permanent records.
A purchaser will often require the seller to amend the LLC’s operating agreement prior to closing to remove the “non-identical governing provision(s).” Notwithstanding the relative ease by which relief is secured in situations where an operating agreement contains one or more “non-identical governing provisions,” a purchaser must evaluate through appropriate diligence whether the target LLC S corporation meets the eligibility requirements for such relief – in particular, whether the LLC has ever made (or is deemed to have made) disproportionate distributions while it purported to be an S corporation. This can be a challenging endeavor in situations where an LLC has been operating as a S corporation for many years, where the LLC has many members, or where members have been added or removed. Accordingly, a purchaser is well advised to include relevant representations and warranties and post-closing covenants in the applicable transaction documents and negotiate indemnities (potentially supported by escrows) where appropriate. A purchaser might also consider an alternative acquisition structure if the target LLC S corporation is ineligible for relief under Revenue Procedure 2022-19 (or there is sufficient uncertainty as to whether the target LLC S corporation is eligible for relief) and the time to obtain relief from the IRS pursuant to Code Section 1362(f) would extend beyond the desired closing horizon.
CONCLUSION
Purchasers and sellers should carefully review the operating agreement of a target LLC that has been operating as an S corporation because of the risk that provisions in its operating agreement may invalidate an otherwise valid S Election. Depending on how a transaction is structured, an invalid S Election can result in adverse tax consequences. Fortunately, Revenue Procedure 2022-19 provides taxpayers with an easier procedure for obtaining relief for inadvertent and minor errors that might invalidate an otherwise valid S Election. A purchaser must still carefully evaluate whether the target LLC S corporation is eligible for such relief.
Former associate Olivia Sica also contributed to this article.
