New guidance on S elections and QSub elections


The IRS recently released guidance (Rev. Proc. 2022-19) that expands on the simplified method for taxpayers to request relief for late S corporation, a qualified subchapter S subsidiary (QSub), electing small business trust (ESBT), and qualified Subchapter S trusts (QSST) elections (Rev. Proc. 2013-30) and automatic relief for certain taxpayers requesting relief for late shareholder consents for S elections in community property states (Rev. Proc. 2004-35).


The new guidance also adds new areas where the IRS will not rule in a Private Letter Ruling (PLR), consistent with the guidance provided in the Rev. Proc. 2022-19. Specific topics discussed in Rev. Proc. 2022-19 are examined below.




Non-identical governing provisions


The governing provisions of an S corporation cannot provide for disproportionate distribution or liquidation rights (i.e., non-identical governing provisions) among any shares of stock or else the S corporation will have two classes of stock and will be ineligible to have an S election. This is most often applicable in the context of an S election for an LLC with provisions more common to partnerships, such as distributions or liquidation rights based on capital account balances rather than pro rata amongst the shares of stock.


The IRS provides a new method for relief for non-identical governing provisions. To qualify for relief, the S corporation and its shareholders must satisfy the following requirements: 

  • The corporation has or had one or more non-identical governing provisions
  • The corporation has not made, and for federal income tax purposes is not deemed to have made, a disproportionate distribution to an applicable shareholder
  • The corporation, in a timely manner, filed a return on Form 1120-S for each taxable year of the corporation beginning with the taxable year in which the first non-identical governing provision was adopted and through the taxable year immediately preceding the taxable year in which the corporation made a request for corrective relief
  • Before any non-identical governing provision is discovered by the IRS, all of the requirements of the revenue procedure are satisfied


To request relief, the S corporation must provide all the relevant facts in a statement signed by a corporate officer and each shareholder must also consent to the election. The corporation must provide an explanation of how each non‑identical governing provision was discovered, and explain each action taken to correct or remove each non-identical governing provision. The description must include each action taken by the corporation and each applicable shareholder to establish that the corporation and each applicable shareholder acted reasonably and in good faith in correcting or removing each non-identical governing provision upon discovery to demonstrate reasonable cause for relief.


Note that consent is required from each applicable shareholder. Applicable shareholders include current or former shareholders of the corporation who own or owned stock of the corporation at any time during the period beginning on the date on which the non-identical governing provision was adopted, and ending on the date on which the non-identical governing provision was removed or modified to comply with the one class of stock requirement.


The corporation will retain the corporate governing provision statement, the shareholder statements and the revised governing provisions in their corporate records. There is no need to notify the IRS of the corporation’s identification of the non-identical governing provisions, the change in governing provisions or the qualification for relief under Rev. Proc. 2022-19. Instead, if the IRS examines the corporation, the corporation must then provide the documentation to support meeting the requirements for relief under the revenue procedure.


The IRS provides an example of a corporate governing provision statement in Appendix A of Rev. Proc. 2022-19, and an example of a shareholder statement in Appendix B.


If the S corporation or applicable shareholder does not qualify under Rev. Proc. 2022-19, the S corporation or shareholder can request a PLR.




Principal purpose determinations regarding the one class of stock requirement



An S corporation cannot have more than one class of stock, per Section 1361(b)(1)(D) and Treas. Reg. Sec. 1.1361-1(l)(1). Generally, a corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, “governing provisions”).


A commercial contractual agreement is not a binding agreement relating to distribution and liquidation proceeds — and therefore is not a governing provision — unless a principal purpose of the agreement is to circumvent the “one class of stock” requirement.


The regulations also identify numerous other agreements and arrangements between or among an S corporation and its shareholders that may or may not be treated as second classes of stock depending in part on whether a principal purpose of the agreement or arrangement was to circumvent the one class of stock requirement or otherwise alter shareholders' rights to distribution and liquidation proceeds. For example, see: 

  • Treas. Reg. Sec.1.1361-1(l)(2)(iii)(A) (buy-sell agreements among shareholders, agreements restricting the transferability of stock and redemption agreements)
  • Treas. Reg. Sec.1.1361-1(l)(4)(ii)(A) (special rules for instruments, obligations or arrangements treated as equity under general principles of federal tax law)
  • Treas. Reg. Sec.1.1361-1(l)(4)(ii)(B)(1) (short-term unwritten advances that fail the safe harbor described in Treas. Reg. Sec. 1.1361-1(l)(4)(ii)(B)(1))
  • Treas. Reg. Sec.1.1361-1(l)(4)(ii)(B)(2) (obligations of the same class that are considered equity under general principles of federal tax law but fail the safe harbor described Treas. Reg. Sec. 1.1361-1(l)(4)(ii)(B)(2))


The IRS also has added a no-rule provision on whether a principal purpose of an arrangement is to avoid the “one class of stock” requirement to be an S corporation. It was added to the no-rule list because determining a “principal purpose” is inherently fact-specific.




Disproportionate distributions



The governing provisions of an S corporation cannot provide for disproportionate distribution or liquidation rights among any shares of stock, or else the S corporation will have two classes of stock and will be ineligible to have an S election. This is further broken down between permanent and timing difference in distribution rights.


An S corporation is not allowed to have permanent differences in distribution and liquidation rights. However, there can be timing differences in when the distributions among different shares of stock are allowed. For a timing difference to be acceptable to the IRS, there must be “an appropriate tax effect in accordance with the facts and circumstances.” A factual question arises on whether an appropriate tax effect has been provided to a timing difference in the distributions and whether this will terminate the S election. The IRS has clarified its position that it will not treat any disproportionate distribution as violating the one class of stock requirement as long as the governing provisions provide for identical distribution and liquidation rights among shares of stock. In addition, the IRS has provided for a no-rule on whether an “appropriate tax effect” has been provided when there are timing differences in distributions. This eliminates the risk of how to apply the “appropriate tax effect” from a second class of stock analysis, but it does not eliminate it from an income tax perspective. Taxpayers should still consider how to give appropriate tax effect to timing differences in distributions based upon the specific facts and circumstances requiring the need to provide a difference in the timing of the distributions.



Certain inadvertent errors or omissions on Form 2553 or Form 8869



An inadvertent error or omission on Form 2553 or Form 8869 does not invalidate an S election or a QSub election unless the error or omission is with respect to a shareholder consent, a selection of a permitted year (as defined in Section 1378(b) and Treas. Reg. Sec. 1.1378-1(b)), or an officer's signature. There is already guidance available to correct each of these specified errors if certain requirements can be met. If the requirements cannot be met, then the taxpayer can request a PLR.


Rev. Proc. 2022-19 provides a method to correct errors that are not among the items specified — for example, the use of an incorrect EIN, address, incorporation date, or state of incorporation among other administrative errors.


To perfect the Form 2553 or Form 8869, taxpayers will write a letter explaining the errors or omissions, and the necessary corrections to the service center where the form was filed.



Missing administrative acceptance letter for S election or QSub election



When a taxpayer files Form 2553 for an S election or Form 8869 for a QSub election, the IRS will provide a written acknowledgement of the acceptance of the election. The written acknowledgement is an administrative item that does not affect the election. A new letter can be requested from the IRS by calling and requesting a duplicate letter.


A PLR is not available with regard to any missing administrative acceptance letter.




A federal income tax return filing inconsistent with an S election or a QSub election



Rev. Proc. 2022-19 verifies that filing a return (Form 1065 or 1120) inconsistent with an S (or QSub) election does not by itself terminate the validity of the S (or QSub) election. Rather, Rev. Proc. 2022-19 provides the taxpayer must file a federal income tax return for open taxable years consistent with its status.


Grant Thornton insight

Note that depending upon the type or return filed and the facts and circumstances surrounding the filing, the statute of limitations may not have started.


The IRS will not issue a PLR to address any inconsistent return filing. This raises concerns about how to perfect the records of the entity with the inconsistent tax filing in closed statute years. The IRS provides, “[T]he corporation’s distributions and other transactions will be treated as consistent with its status as an S corporation or a QSub, as appropriate. Thus, a QSub's income or deductions will be treated as income or deductions of the parent S corporation and distributions between the QSub and its parent will be disregarded.” However, there may be additional technical issues that will need to be resolved depending upon the facts and circumstances.



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