For entities that meet the statutory definition of a “small business corporation,” electing to be classified as an S corporation for US federal income tax purposes provides protection from entity-level taxation along with other tax-related and practical advantages. And, for private equity investors or other parties involved in mergers and acquisitions (M&A), it’s important to understand how an organization’s S-corporation status might cause tax-related impacts in the event of a potential M&A transaction.

The requirements outlined in Internal Revenue Code (IRC) § 1361 to qualify as an S corporation are very specific and state that an entity’s S-corporation election will automatically terminate upon the occurrence of any event that causes the entity to no longer meet the definition of a small business corporation. Specifically, an entity will no longer qualify as a small business corporation if (among other things) at any time it issues a second class of stock, gains more than 100 shareholders, or has an ineligible shareholder.

What are the risks associated with the inadvertent termination of S-corporation status?

Maintaining these requirements may seem straightforward, but, in practice, simple actions taken by an S corporation or its shareholders can have the adverse effect of inadvertently terminating the entity’s S-corporation election. As a result, the S corporation (which was intended to be treated as a pass-through entity for US federal income tax purposes for which taxable gains and/or income were not subject to entity-level taxation) may instead be deemed a C corporation, for which taxable income and gains are subject to entity-level corporate tax.

This can have significant impacts in the context of a merger or acquisition. During an M&A transaction, a buyer may be subject to successor liability related to any tax exposure from the failed election, including penalties and interest. Identifying these issues during the tax due diligence process can allow a buyer to select the most tax-efficient transaction structure to mitigate inherited risks, indemnify any concerns noted in diligence, and, if necessary, begin the process of remediation.

Guidance continues to evolve regarding the S-corporation election and inadvertent terminations, so business owners and potential sellers should be diligent in ensuring that their actions are in alignment with the regulations around S-corporation qualification. In order to avoid potentially costly mistakes upon the sale of a business, it’s beneficial to engage qualified tax professionals upon the formation of an S corporation and to regularly consult with those professionals when personal or business-related changes occur.

How can the inadvertent termination of S-corporation status occur?

Common examples of situations that may result in the termination of an S-corporation election may include:

• Timing of filing – The shareholders of an operating C corporation intend to begin operating as an S corporation as of January 1 of Year 5. In the hustle of the new year, the shareholders do not file Form 2553, Election by a Small Business Corporation, by its due date on March 15 of Year 5 and instead make the election on April 1 of Year 5. The election cannot be effective retroactively and would instead cause the C corporation to convert to an S corporation effective January 1 of Year 6. During Year 5, the C corporation would still be responsible for entity-level taxes.⁽¹⁾
• Community property laws impacting shareholders and their spouses – Community property laws dictate that any property belonging to the shareholder becomes community property with the spouse of the shareholder. For example, if a US citizen owns a business and elects for it to become an S corporation, but the business owner is a resident of a community property state and is married to a nonresident alien (which is an ineligible type of shareholder for S corporations⁽²⁾), then the nonresident alien will become a shareholder of the S corporation by operation of law. This makes the business ineligible to become an S corporation.
• Agreements classified by the IRS as an impermissible type of stock – One of three shareholders in an S corporation enters into a written loan agreement with the S corporation for $50,000, specifying interest payments to the shareholder are to be made at a market rate. The agreement further stipulates that interest payments will be dependent on profit such that, in years when the S corporation has an operating loss, no interest will be paid. The Internal Revenue Service may challenge this note as an impermissible second class of stock as it effectively provides for disproportionate distributions to one of the S corporation’s shareholders.⁽³⁾

Typically, once a corporation has revoked or terminated its S corporation election, the corporation (or a successor corporation) must wait five years before it can re-elect S corporation status unless the IRS consents to waive the five-year period.⁽⁴⁾

How can strategic tax structuring help alleviate the risks associated with an S corporation’s inadvertent termination?

From a transactional perspective, an F reorganization may preserve the benefits of a step-up in tax basis for a buyer when a seller is unable to substantiate the target’s status as an S corporation. Although such a form of transaction preserves the desired step-up in tax basis for the buyer, it does not generally protect the buyer from potential liabilities of the historical S corporation, including, but not limited to, issues and entity-level exposures resulting from an invalid S corporation election.⁽⁵⁾

Another common structure seen in transactions involving S corporations is a joint election under Section 338(h)(10), which allows the buyer to treat a legal purchase of stock as an asset deal for US federal income tax purposes, allowing the buyer to achieve a step-up in tax basis. This joint election requires, among other things, a valid S corporation or qualified subsidiary as a target. Although asset treatment is favorable for a buyer, sellers may require compensation for the additional tax liabilities resulting from their sale of assets. This could be a point of negotiation in these transaction structures.

How has the IRS historically treated S corporations facing a potential inadvertent termination?

Historic case law and private letter rulings (PLRs) provide examples in which businesses have obtained relief from the inadvertent termination of S-corporation status. Generally, the IRS has provided relief to S corporations (via a waiver) and has potentially restored S-corporation status retroactively if:

• The corporation previously made a valid S-corporation election and that election had been terminated;
• The subchapter S election qualification loss was triggered by an inadvertent act;
• The IRS determines that the termination was inadvertent, generally via a PLR;
• Steps are taken within a reasonable period to correct the condition that rendered the corporation ineligible to be an S corporation; and
• The corporation and persons who were shareholders during the period of the termination agree to make any adjustments the IRS requires that are consistent with the treatment of the corporation as an S corporation.

Examples of favorable rulings related to common examples of inadvertent terminations include:

• Two key revenue procedures provide relief for failure to file an S-corporation election or late filings of such election. The first states that a corporation that failed to make an S-corporation election and learned of its failure prior to filing its Form 1120S for the year the election was to be effective could file Form 2553 by the earlier of (i) eighteen months from the original due date of the S election, or (ii) six months after the due date (excluding extensions) of the first return for which the election was to be effective. If the corporation doesn’t learn of its failed S corporation election until after it’s filed its Form 1120S for the year the election was to become effective, the late Form 2553 is due by 24 months from the due date of the election. The second granted additional leniency by permitting a corporation that failed to make an S corporation election but that had not yet filed its Form 1120S for the first tax year it wanted the election to be effective to attach a late Form 2553 to the return, provided the return was filed by its extended due date.⁽⁶⁾
• Several private letter rulings address situations where S corporation equity was unknowingly transferred to ineligible shareholders and, upon discovery of the potential termination, each S corporation took corrective action. The IRS ruled in each situation that the S corporation election terminated when the ineligible person or entity became a shareholder but that this termination constituted an inadvertent termination within the meaning of IRC § 1362(f), and the corporation would be treated as an S corporation, provided that its election was otherwise valid and had not otherwise terminated under IRC § 1362(d).⁽⁷⁾
• In one PLR, an S corporation failed to make distributions to all its shareholders. Upon discovery of the disproportionate distribution in the following year, the S corporation made the necessary corrective distributions and sought out a ruling. The IRS determined that the S Corporation election may have been terminated because of disproportionate distributions creating a second class of stock, but that because the termination was deemed inadvertent and corrective action was taken, the S corporation would still be treated as an S corporation from the date of initial election as long as the election was not otherwise terminated. The US Tax Court’s ruling in Linda K. Minton v. Commissioner further upheld this position provided, in part, in Treas. Reg. § 1.1361-1(l)(2)(i), that disproportionate distributions would not create a second class of stock —and thus would not terminate an S Corporation election— if such distributions were made under oral or informal agreement and are not contained in the S Corporations “governing provisions,” which include documents such as its corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds.⁽⁸⁾

The rulings and case law as described above demonstrate that the IRS has historically tended to rule favorably for continuation of an entity’s S-corporation classification in situations where the termination was truly inadvertent, and when corrective action was immediately taken upon identification of the potentially terminating incident. Despite the potentially favorable outcomes, the process of getting a private letter ruling is often time-consuming and costly.

Further, applying such law requires a detailed analysis of each S corporation’s specific facts to consider how they align with the facts as presented in each case or ruling. Generally, the IRS has the administrative authority to determine whether an inadvertent termination has occurred and whether a waiver of such termination is available.

How is the IRS changing the way it addresses an S corporation’s inadvertent termination?

During 2017, representatives from the IRS indicated that, due to resource constraints, the IRS will no longer issue letter rulings to S corporations on disproportionate distributions, specific second-class of stock issues, or incorrect entity filings.

Instead, in October of 2022, the IRS issued Revenue Procedure 2022-19 to provide taxpayer assistance procedures to allow S corporations and their shareholders to resolve frequently encountered issues with certainty and without requesting private letter rulings. The Revenue Procedure specifically addresses and outlines procedures to address six key areas:

• the single class of stock requirement and governing provisions, including “principal purpose” conditions;
• disproportionate distributions;
• certain inadvertent errors on or omissions from Forms 2553 (S election) or Form 8869 (QSub election), which Rev. Proc. 2013-130 and Rev. Proc. 2004-35 do not address;
• missing administrative acceptance letters for an S election or QSub election;
• federal income tax return filings inconsistent with an S election or a QSub election; and
• potential retroactive corrections of nonidentical governing provisions (e.g., rights to distributions or liquidation proceeds that are not identical among shareholders).

With the release of this revenue procedure, skilled tax advisors may be able to advise their S corporations encountering the common scenarios addressed above and determine how to gain relief for inadvertent terminations—without the significant time, cost, and potential administrative burden of a private letter ruling. A trained tax specialist engaged to assist with tax-efficient transaction structuring may also be able to propose a transaction structure that relieves a buyer of the potential cash tax exposures associated with an invalid S-corporation election.

(1) Internal Revenue Code § 1362(b)

(2) Internal Revenue Code § 1361(b)(c)

(3) Internal Revenue Code § 1361(c)(5)(B)

(4) Internal Revenue Code § 1362(g)

(5) Internal Revenue Code § 386(a)(1)(F)

(6) Rev. Proc. 2003-43 and Rev. Proc. 2007-62

(7) PLRs 201028024, 201017009, 201027001 and 202347006

(8) PLR 200944018