IRS Finalizes Eligible Terminated S Corporation Regulations

(Parker Tax Publishing September 2020)

The IRS finalized regulations on the definition of an "eligible terminated S corporation" (ETSC), as well as regulations relating to distributions of money by an ETSC after an S corporation post-termination transition period (PTTP). The IRS also amended the regulations to eliminate the no-newcomer rule and extend the treatment of distributions of money during the PTTP to all shareholders of the S corporation. T.D. 9914.

Background

Generally, a distribution by a C corporation to its shareholders with respect to their stock ownership is treated as a taxable dividend to the extent of the corporation's earnings and profits. However, following the termination of a corporation's S election, Code Sec. 1371(e) allows shareholders of the resulting C corporation to benefit from the corporation's former status as an S corporation with respect to distributions of money during the corporation's post-termination transition period (PTTP), which is generally the one-year period after the corporation terminates its S election. Specifically, during the PTTP, a distribution of money by the C corporation is characterized as a distribution from the corporation's accumulated adjustments account (AAA). The receipt of such a distribution is tax-free to the extent of the recipient shareholder's basis in its stock and the corporation's AAA balance. If the distribution exceeds the recipient shareholder's basis in its stock, but not the corporation's AAA, then the distribution is tax-free to the extent of the recipient shareholder's basis, with the remainder treated as gain from the sale of property. If the distribution exceeds the corporation's AAA, then the excess is taxed as a dividend from current earnings and profits (CE&P)) or any AE&P from the corporation's previous existence as a corporation taxed under subchapter C. Without Code Sec. 1371(e), shareholders of the former S corporation would be precluded from receiving distributions allocable to AAA.

The Tax Cuts and Jobs Act of 2017 (TCJA) added new Code Sec. 481(d) and Code Sec. 1371(f), effective as of December 22, 2017 (i.e., the date of enactment of the TCJA). Code Sec. 481(d)(1) permits a corporation that qualifies as an eligible terminated S corporation (ETSC) to take into account any Code Sec. 481 adjustments which are attributable to the revocation of an S election over the Code Sec. 481(d) inclusion period, which is the six-tax-year-period beginning with the year of change.

An ETSC is defined in Code Sec. 481(d)(2) as a C corporation meeting the following three requirements: (1) the corporation was an S corporation on December 21, 2017; (2) the S corporation revoked its election under Code Sec. 1362(a) to be an S corporation (that is, the S election) during the two-year period beginning on December 22, 2017 (revocation requirement); and (3) the owners of the stock of the corporation, determined on the date the corporation made a revocation of its S election, are the same owners (and own identical proportions of the corporation's stock) as on December 22, 2017 (shareholder identity requirement).

Code Sec. 1371(f) extends the period during which shareholders of an ETSC can benefit from its AAA generated during the corporation's former status as an S corporation (ETSC period) by providing that, in the case of distributions of money following the PTTP, the distributing ETSC's AAA is allocated to a distribution of money to which Code Sec. 301 would otherwise apply (qualified distribution), and the qualified distribution is chargeable to AE&P in the same ratio as the amount of such AAA bears to the amount of such AE&P. In enacting Code Sec. 1371(f), Congress determined that it was important to provide rules to ease the transition from S corporation to C corporation for the affected taxpayers because, based on the TCJA's revisions to the Code, taxpayers that previously elected to be taxed as S corporations may prefer instead to be taxed as C corporations.

In November of 2019, the IRS issued proposed regulations in REG-131071-18 under Code Sec. 1371, Code Sec. 481, and Code Sec. 1377 relating to the ETSC changes made by the TCJA. The IRS has now finalized those regulations in T.D. 9914 with some modifications in response to comments received.

Compliance Tip: The final regulations apply to tax years beginning after the date these regulations are published in the Federal Register. However, a corporation can choose to apply them in their entirety to tax years beginning on or before such date if all shareholders of the corporation consistently report and apply the rules in their entirety for the corporation's subsequent tax years.

Revocation Date

The date on which a corporation revokes its S election is critical for determining ETSC qualification. A corporation can allow the effective date of its S election revocation to occur automatically by operation of Code Sec. 1362(d)(1)(C), or it can specify an effective date under Code Sec. 1362(d)(1)(D). For example, a revocation made before the 16th day of the third month of an S corporation's tax year generally is effective retroactively on the first day of that tax year.

In contrast, under Code Sec. 1362(d)(1)(C)(ii), a revocation made after the 15th day of the third month of a corporation's tax year generally is effective prospectively on the first day of the corporation's following tax year. Alternatively, the corporation may specify an immediate or prospective effective date for a revocation by expressing a date (in terms of a stated day, month, and year) that occurs on or after the date on which the revocation is made.

In response to a practitioner's comment, the IRS modified the regulations so that Reg. Sec. 1.481-5(c)(2) provides that, solely with regard to revocations with retroactive effective dates, a revocation may be treated as having been made on the effective date of such revocation. Accordingly, a corporation may test compliance with the revocation requirement and the shareholder identity requirement on either the date the revocation was made or, in the case of a revocation with a retroactive effective date, the date the revocation was effective.

Observation: The practitioner had noted that, under the proposed regulations, in the absence of such a rule, a corporation would not satisfy the shareholder identity requirement for qualifying as an ETSC if the corporation (i) had the same shareholders (and in identical proportions) on both December 22, 2017, and the retroactive effective date of the revocation, but (ii) experienced a change in shareholder ownership during the period between the retroactive effective date of the revocation and the date on which the revocation was made.

In addition, the final regulations clarify the text of Reg. Sec. 1.1362-2(a)(2) to provide explicitly that Code Sec. 7503 applies where the last day prescribed for making a revocation occurs on a Saturday, Sunday, or legal holiday. Therefore, under the revocation provision that requires that a corporation make a revocation during the two-year period to qualify as an ETSC, a revocation made on December 23, 2019, will be treated as made during the two-year period for purposes of this rule.

No-Newcomer Rule

A no-newcomer rule in the last sentence of Reg. Sec. 1.1377-2(b), as in effect prior to the effective date of the final regulations, limited the special treatment provided under Code Sec. 1371(e)(1) (with respect to distributions of money during a corporation's PTTP) solely to those shareholders who were shareholders of the corporation at the time that it terminated or revoked its S election (i.e., legacy shareholders).

In the proposed regulations, the IRS noted that in the absence of a no-newcomer rule, shareholders that were shareholders on the date that the corporation's S election revocation was made would continue to receive qualified distributions, whether or not there are new shareholders or changes in the historical S corporation shareholders' proportionate interests on or after such date. Moreover, new shareholders, whether eligible S corporation shareholders or not, that acquire stock of an ETSC on or after the date that the revocation was made may receive qualified distributions, all or a portion of which may be sourced from AAA. According to the IRS, such outcomes would best implement the plain language of Code Sec. 1371(f) and the policy objective of easing the transition of affected taxpayers from S corporation status to C corporation status. Accordingly, the proposed regulations did not impose a no-newcomer rule with respect to the ETSC period. Because the rules pertaining to the PTTP and to the ETSC period serve a similar objective of easing the transition from S corporation to C corporation status, the IRS determined that the rules regarding newcomers (i.e., non-legacy shareholders) should be consistent. Therefore, based on the rationale for rejecting a no-newcomer rule with respect to the ETSC period, the IRS determined that such a rule should also not apply with respect to the PTTP and proposed the removal of the no-newcomer rule.

A practitioner recommended that the final regulations include an additional transition rule where, if shares of a former S corporation were transferred to a newcomer pursuant to a binding agreement entered into before the applicability date of the final regulations, then, except upon unanimous agreement of current shareholders of a corporation that are legacy shareholders, the no-newcomer rule would apply during the PTTP, and a similar rule would apply during the ETSC period. The IRS, however, rejected the recommendation saying that it intended the applicability date provisions in the proposed regulations, and as adopted in the final regulations, to afford corporations transition flexibility in applying Reg. Sec. 1.1377-2(b) with regard to the PTTP. Reg. Sec. 1.1377-2(b), as revised by the final regulations to eliminate the no-newcomer rule for special treatment under Code Sec. 1371(e)(1) of distributions of money by a corporation with respect to its stock during the PTTP, applies to a corporation's tax years beginning after the date of publication of the final regulations. In the case of a corporation using the calendar year as its annual accounting period, newcomers are not entitled to receive distributions of AAA before January 1, 2021, unless the corporation chooses to apply Reg. Sec. 1.1377-2(b) before January 1, 2021. Corporations to which the commenter's transition rule would have applied generally will thus have completed their PTTPs prior to the applicability of Reg. Sec. 1.1377-2(b). Distributions of AAA during those PTTPs would have been limited to legacy shareholders. Additionally, the IRS said, the practitioner's proposed transition rule would add complexity in administering the rules.

For a discussion of the rules surrounding ETSCs, see Parker Tax ¶34,580.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com