The IRS recently provided guidance addressing inadvertent terminations of S Corporation (S Corp) status based on existing provisions in corporate documents that remain after a company makes an S Corp election. This can be a complex legal task that aims to harmonize documents for clarity and consistency in their interpretation and application. In this Part 2 of the blog series “Focus on S Corporations,” PilieroMazza offers guidance to businesses on how to make corrections after an S Corp election to properly safeguard personal and business assets from significant monetary and compliance risks. Visit this link for Part 1 in the blog series.
Background
For many reasons, the limited liability company (LLC) established itself as the preferred legal entity type for small businesses. Many find that the benefits of an LLC can be extended further if an eligible business makes an S Corp election, which provides the tax advantages of a pass-through entity while avoiding the traditionally disliked pitfalls of corporate taxation.
To qualify for S Corp status, the entity must meet certain requirements. In practice, we find that tax professionals advise existing LLCs make the S Corp election along with usual annual tax filings, without first evaluating the LLC’s governing documents or other legal considerations. Because the election is made through filing a simple form, business owners do not appreciate the significance of making the election. Often, the fact that an LLC made the S Corp election will be mentioned to us in passing, but clients must be aware that certain steps must be taken to bring the LLC’s governing documents into compliance. As discussed below, if the S Corp requirements are not constantly maintained, S Corp status can be terminated retroactively, with dire tax consequences.
Termination of S Corp Status
If the corporate requirements and best practices are not maintained, S Corp status can be terminated retroactively to the date of the event triggering the violation of S Corp rules. This will trigger administrative and tax consequences since the IRS treats the termination as a taxable event—potentially creating major consequences. The consequences vary depending on each entity’s financial position at the time of termination and should be carefully reviewed with an accountant. Additionally, an S Corp that loses its status as an S Corp will default to taxation as a C Corp on the day of the termination. This means the entity is subject to double taxation where the business’ income is taxed at the corporate level and again at the individual level when dividends are distributed to shareholders.
Entities that violate S Corp status are generally prohibited from making a new S Corp election for five years. This prohibition also applies to any successor entity. Therefore, it’s crucial for businesses to understand the requirements for maintaining S Corp status and take steps to ensure compliance. Also, when a violation of S Corp rules is discovered, there are corrective measures entities can take to get back into valid S Corp status.
“Inadvertent” Terminations
The IRS consistently made clear that certain actions automatically trigger termination of S Corp status. Common examples include filing a return with disproportionate distributions, reporting a non-allowable shareholder, or exceeding certain limits on retained earnings and/or passive income. In cases of an “active” violation of S Corp rules, the S Corp status was terminated. If the S Corp termination was intentional, the S Corp would simply file in its new tax status after the termination.
If the termination was a mistake, the entity could seek relief for an “inadvertent” termination. An inadvertent termination includes situations where an S Corp made a one-time disproportionate distribution, which was a clerical mistake and immediately corrected. While technically this violates S Corp requirements and triggers a termination of S Corp status, Congress made clear that businesses should be granted wide latitude for mistakes and technical issues. As such, the entity can take certain steps to restore S Corp status, including applying to the IRS for a Private Letter Ruling (PLR).
Absent active steps, it is less clear how to address when the company’s governing documents merely permitted a violation of S Corp rules. In the past, if an existing LLC made an S Corp election, the company would usually take the internal step of simply updating its operating agreement with S Corp provisions after the election. As long as the S Corp requirements were not actually violated, many professionals assumed that the S Corp status was not terminated and that there was no need for corrective filings with the IRS.
Revenue Procedure 2022-19
On October 11, 2022, the IRS issued Revenue Procedure 2022-19[1], which at once simplified and complicated “inadvertent” terminations of S Corp status. First, rather than obtaining a PLR to determine S Corp status after an inadvertent termination, this Revenue Procedure provides a simplified process to cure accidental terminations. An entity qualifying for the simplified process can file certain corporate documents with its books and records in lieu of a PLR; in other words, fixing the issue is handled internally, not with the IRS.
More importantly, the Revenue Procedure also added concrete clarity that the mere existence of a “non-identical governing provision” is sufficient to terminate S Corp status. Again, this is true whether or not one of the S Corp requirements was actually terminated.[2] This is because the IRS does not exclusively look to the actions of the company; rather, the IRS evaluates the governance documents and any other binding agreements relating to distribution and liquidation proceeds.[3] As a prime example, a provision that merely authorizes a disproportionate distribution is deemed to automatically terminate S Corp status, regardless of whether any actual distributions were made.
The few other examples of “non-identical governing provisions” provided in the Revenue Procedure that would trigger automatic termination are boilerplate terms that are seen in most operating agreements designed for LLCs taxed as partnerships. The applicability here is broad and impactful for companies electing S Corp status, and any company preparing to make the election should first work with an attorney to mitigate any issues prior to the election.
Identifying and Addressing the Problem
Inadvertent terminations are expected to occur most often when: (1) an LLC electing S Corp adopts a “standard” operating agreement at the time of organization or (2) where an existing LLC taxed as a partnership or sole proprietorship has a “standard” operating agreement and then elects S Corp status without first updating its operating agreement prior to making the election. If the company has “bad” provisions in its existing operating agreement—and elects S Corp status while the operating agreement is binding—then the S Corp status is deemed automatically terminated.
Importantly, the simplified procedure described above can only be used if the entity proactively fixes the issue in accordance with updated guidance. Specifically, the entity must fulfill all of the requirements for the simplified procedure “[b]efore any non-identical governing provision is discovered by the IRS.”[4] In any event, such actions must be taken within a reasonable period of time after discovery of the inadvertent termination.[5]
Takeaway
Retroactively correcting corporate documents after an S Corp election can be a complex legal process, and the specific steps and considerations may vary depending on the jurisdiction and the nature of the provisions in question. To protect your personal and business assets, it is essential to work closely with an attorney who can guide you through the process effectively and ensure legal compliance.
[1] Rev. Proc. 2022-19 (Internal Revenue Bulletin 2022-41), October 11, 2022, https://www.irs.gov/pub/irs-irbs/irb22-41.pdf.
[2] Rev. Proc. 2022-19, § 2.03(6)(a).
[3] See 26 C.F.R. § 1.1361-1(l)(2)(i).
[4] Rev. Proc. 2022-19, § 3.06(2)(b)(iv).
[5] 26 U.S.C. § 1362(f)(3).
