Proposed Regs on Eligible Terminated S Corporations Introduce New Priority Rule for Sourcing Distributions

(Parker Tax Publishing November 2019)

The IRS issued proposed regulations, on which taxpayers may currently rely, which would (1) provide rules on the definition of an eligible terminated S corporation (ETSC); (2) provide rules relating to distributions of money by an ETSC after the post-termination transition period (PTTP); and (3) revise current regulations to extend the treatment of distributions of money during the PTTP to all shareholders of the corporation and to update and clarify the allocation of current earnings and profits to distributions of money and other property. Based on Congress' objective to ease affected taxpayers' transition from S corporation status to C corporation status, the proposed regulations provide a special sourcing rule, which would apply the rules of Code Sec. 1371(f) before the rules of Code Sec. 301 and Code Sec. 316, for qualified distributions. REG-131071-18.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) amended the Code to add Code Sec. 481(d) and Code Sec. 1371(f). Both provisions are effective as of December 22, 2017.

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 an S corporation'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 S election terminates. 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), as defined in Reg. Sec. 1.1368-2(a)(1). The receipt of such a distribution is tax-free to the extent of the recipient's basis in its stock with respect to which it received the distribution, and is taxed as gain from the sale of property to the extent the distribution exceeds the recipient's basis in that stock. If the corporation exhausts its AAA during the PTTP, then subsequent distributions are subject to treatment under Code Sec. 301. Without Code Sec. 1371(e), shareholders of the former S corporation would be precluded from receiving distributions allocable to AAA.

Code Sec. 1371(f) extends the period during which the shareholders of a C corporation can benefit from AAA generated during such corporation's former status as an S corporation. This is referred to as the eligible terminated S corporation (ETSC) period. During this period, a C corporation's distribution of money to which Code Sec. 301 would otherwise apply (qualified distribution) is sourced, in whole or in part, from AAA. Specifically, Code Sec. 1371(f) provides that (1) the distributing ETSC's AAA is allocated to a qualified distribution, and (2) the qualified distribution is chargeable to accumulated earnings and profits (AE&P), in the same ratio as the amount of such AAA bears to the amount of such AE&P (i.e., the ETSC proration).

In enacting Code Sec. 1371(f), Congress provided that "it is important to provide rules to ease the transition from S corporation to C corporation for the affected taxpayers" because, based on TCJA revisions to the Code, taxpayers that previously elected to be taxed as S corporations may prefer instead to be taxed as C corporations.

Requirements to Qualify for Section 1371(f) Treatment

If a C corporation satisfies the ETSC qualification requirements, Code Sec. 1371(f) provides special treatment for qualified distributions made by an ETSC during the ETSC period, which begins with the expiration of the PTTP and ends when the corporation exhausts its AAA.

In conjunction with the enactment of Code Sec. 1371(f), Congress enacted Code Sec. 481(d), which includes the definition of an ETSC. Specifically, a C corporation qualifies as an ETSC if the following three requirements are satisfied: (1) the corporation was an S corporation on December 21, 2017; (2) during the two-year period beginning on December 22, 2017, the S corporation revoked its S election (revocation requirement); (3) the owners of the stock of the corporation are the same owners (and in identical proportions) on December 22, 2017, and on the date that the corporation made a revocation of its S election (shareholder identity requirement).

In contrast to the PTTP, which applies regardless of how an S corporation's election terminates, Code Sec. 1371(f) applies only if the S election is revoked which, under Code Sec. 1362(d)(1)(B), requires the consent of shareholders holding more than 50 percent of the corporation's shares in the aggregate.

As noted above, for a former S corporation to qualify as an ETSC, the owners of its stock must be the same owners (and in identical proportions) on the following two dates: (1) December 22, 2017, and (2) the date on which the S corporation made a revocation of its S election. However, certain events should not affect the shareholder identity requirement because such events would not change in substance the identity of the subject shareholder. Specifically, the proposed regulations identify five categories of stock transfers that do not result in an ownership change for purposes of Code Sec. 481(d): (1) transfers of stock between a shareholder and that shareholder's trust treated as wholly owned by that shareholder under the grantor trust rules; (2) transfers of stock between a shareholder and an entity owned by the shareholder that is disregarded as separate from its owner; (3) an election by a shareholder trust to be treated as part of a decedent's estate under Code Sec. 645 or the termination of an election under that provision; (4) a change in the status of a shareholder trust from one type of eligible S corporation shareholder trust described in Code Sec. 1361(c)(2)(A) to another type of eligible S corporation shareholder trust; and (5) a transaction that includes more than one of the events described in (1) through (4).

Code Sec. 1371(f) provides that AAA is allocated to a qualified distribution based on the ratio of AAA to AE&P. Thus, if an ETSC has no AAA, Code Sec. 1371(f) does not apply.

Observation: A PTTP may occur during the 120-day period beginning on the date of any determination pursuant to an audit of a taxpayer that follows the termination of the corporation's election and adjusts an S corporation item that arose during the S period (intervening audit PTTP). Code Sec. 1371(f) applies to certain distributions after the PTTP. The IRS was asked to consider whether the ETSC period continues following an intervening audit PTTP that occurs during the ETSC period. Based on the overall purpose of the proposed regulations to ease the transition from S corporation status to C corporation status, the IRS determined that the ETSC period should resume immediately following the conclusion of an intervening audit PTTP, if the ETSC continues to have an AAA balance greater than zero.

Mechanics of Section 1371(f)

By its terms, Code Sec. 1371(f) does not require the recipients of qualified distributions to have been shareholders of the S corporation at the time of revocation, and no part of the House Report indicates a Congressional intent to impose such a limitation (i.e., a no-newcomer rule) on such distributions. The IRS noted that it had received a comment requesting guidance to clarify which shareholders are eligible to receive distributions from a corporation's AAA during the ETSC period. A no-newcomer rule, the IRS said, would be inconsistent with Congressional intent to ease the transition of former S corporations to full C corporation status because such a no-newcomer rule would impede an ETSC's ability to exhaust its AAA. A no-newcomer rule also would impose an administrative burden on ETSCs and create complexity by requiring ETSCs to report distributions disparately depending on the recipient. Additionally, a rule allowing newcomers would be more consistent with treating the AAA as a corporate-level account. 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.

According to the IRS, 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. The IRS concluded that 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 IRS did not impose a no-newcomer rule with respect to the ETSC period.

Code Sec. 1371(f) provides that the distributing ETSC's AAA is allocated to a qualified distribution, and such qualified distribution is chargeable to the ETSC's AE&P, based on the ETSC proration. According to the IRS, the proposed regulations would implement this provision in a manner designed to facilitate the ETSC's prompt distribution of AAA and full transition to C corporation status, and thereby ease the transition from S corporation to C corporation for the affected taxpayers.

Grounded in that policy, the proposed regulations (1) specify the time at which amounts of AAA and AE&P are determined for purposes of the ETSC proration, (2) clarify the AAA and AE&P ratios used to implement the ETSC proration, and (3) describe in detail the method of characterizing qualified distributions.

Based on Congress' objective to ease affected taxpayers' transition from S corporation status to C corporation status, the proposed regulations provide a special sourcing rule (the Section 1371(f) Priority Rule) for qualified distributions. The Section 1371(f) Priority Rule essentially provides that, during the ETSC period, the rules of the ETSC proration under Code Sec. 1371(f) apply before the rules of Code Sec. 301 and Code Sec. 316. Thus, under the Section 1371(f) Priority rule, the ETSC proration first applies to qualified distributions during the tax year. Then, the rules of Code Sec. 301 and 316, as incorporated into the Section 1371(f) Priority Rule, apply to any nonqualified distributions as well as to any qualified distributions or portions thereof that are not fully accounted for by the ETSC proration (i.e., because the corporation's AAA or AE&P are exhausted during the year).

Practice Tip: In the preamble to the proposed regulations, the IRS admits that the application of the Section 1371(f) Priority Rule departs from the allocation and characterization rules under Code Sec. 301 and Code Sec. 316 with which taxpayers and practitioners are familiar. The departure is greatest when an ETSC has both historical AAA and historical AE&P and makes both qualified and non-qualified distributions during the same tax year. For ETSCs with historical AAA but no historical AE&P, which the IRS believes will be the most common situation, the departure is less significant and is the same as the departure that Code Sec. 1371(e) requires for distributions of AAA during the PTTP. Immediately following the end of the tax year in which the ETSC period ends, which occurs when the ETSC's AAA balance is reduced to zero, the normal rules of Code Sec. 301 and Code Sec. 316 apply as usual to all distributions. The proposed regulations are expected to generally reduce the length of the ETSC period and thus reduce the time during which the departure from the normal rules of Code Sec. 301 and Code Sec. 316 occurs. In the preamble, the IRS provides a reference to practitioners for applying the Section 1371(f) Priority Rule to qualified and non-qualified distributions made during the tax years of the ETSC period, including the tax year in which the ETSC period ends.

Effective Date

The regulations are proposed to apply to tax years beginning after the date they are finalized in the Federal Register. However, the proposed regulations provide corporations with the option to apply the final rules in Prop. Reg. Secs. 1.316-2, 1.481-5, 1.1371-1, 1.1371-2, and Prop. Reg. Sec. 1.1377-2 in their entirety, to the extent applicable, to tax years that began on or before the date they are finalized and with respect to which the statute of limitations period described in Code Sec. 6511(a) has not expired. If the corporation makes this choice, all shareholders of the corporation must report consistently.

For a discussion of the rules applicable to an S corporation post-termination transition period, see Parker Tax ¶34,580. For a discussion of distributions by ETSCs, see Parker Tax ¶32,110.

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.

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