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Fourteen sections of the Internal Revenue Code are central to the taxation of Subchapter S corporations and their shareholders. Over the 12-month period ending March 2021, these sections and others affecting S corporations have been addressed by recent legislation, court cases, and IRS guidance. The AICPA S Corporation Taxation Technical Resource Panel, a volunteer group of practitioners who pay close attention to matters affecting S corporations and their shareholders, offers the following summary of recent developments relating to this tax area. The items are arranged by Code section and often contain a short description of the relevant provision.
Section 1361(b) lists several conditions that are necessary for a corporation to be eligible for S corporation status. Among these are a limitation on the number of shareholders at any given time; the limitation of eligible shareholders to individuals, estates, and certain trusts; and the requirement that there only be one class of stock outstanding. There are also specified ineligible corporations, but these are limited to certain banks, life insurance companies, domestic international sales corporations (DISCs) or former DISCs, and corporations that have terminated S corporation or qualified Subchapter S subsidiary status within the past five years. The statute does not specifically address other entities, such as not-for-profit corporations.
Not-for-profit corporation was not allowed to make S election: In Deckard, the Tax Court addressed the ability to make an S election for a nonstock, not-for-profit corporation.
In 2012, Clinton Deckard organized Waterfront Fashion Week Inc. (Waterfront), a nonstock, not-for-profit corporation under Kentucky law. The intended charitable and educational purposes of the organization failed to develop, and Waterfront suffered losses during its first two years in existence (2012 and 2013). Waterfront was dissolved twice under state law for failure to file its annual reports (once in 2013 and again in 2014). Deckard had Waterfront reinstated for 2013 but did not seek reinstatement for 2014. Deckard subsequently filed a retroactive S corporation election for Waterfront and attempted to claim operating losses for 2012 and 2013, as he had funded approximately $275,000 of Waterfront's expenditures via capital contributions.
The Tax Court held that Deckard had no beneficial ownership rights as a shareholder under state law and the articles of incorporation because Waterfront's articles of incorporation provided, among other things, that:
- "No part of the net earnings of the Organization shall inure to the benefit of, or be distributable to its directors, officers or other private persons."
- "The Organization is organized exclusively for charitable and educational purposes";
- "The Organization shall not have members"; and
- "Upon dissolution of the organization, its assets shall be distributed as directed by a two-thirds majority vote of the directors in office for (i) one or more exempt purposes . . ., or (ii) any other federal, state, or local government entity or enterprise established exclusively for a public purpose."
Deckard was thus prohibited from making an S election for Waterfront and was not permitted to claim any losses of Waterfront on his individual return.
Second class of stock created by partnership operating agreement: An S corporation cannot have more than one class of stock (Section 1361(b)(1)(D)). For this purpose, a corporation is treated as having one class of stock if all outstanding corporate shares of stock confer identical rights of distribution and liquidation proceeds. Differences in voting rights are disregarded.2 The determination of whether all outstanding shares meet this condition is based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the "governing provisions"). Commercial agreements, such as contractual agreements, leases, and loan agreements, are not governing provisions unless a principal purpose of an agreement is to circumvent the one-class-of-stock requirement.
Not treated as a second class of stock are instruments, obligations, or arrangements including: many call options; certain short-term unwritten advances and proportionately held debt; straight debt; certain buy-sell and redemption agreements; and certain deferred compensation plans.3
In a private letter ruling,4 the IRS addressed the issue of whether a limited liability company (LLC) had just one class of stock outstanding. As expected, the IRS's focus was on the provisions of the LLC's operating agreement. The operating agreement was drafted as though the entity would be a partnership for federal tax purposes, so it included provisions such as the allocation of profits among members in proportion to their negative capital balances (if any), the allocation of losses among members in proportion to positive capital account balances, and the requirement that liquidating and non-liquidating distributions be made in proportion to capital account balances.
In the letter ruling, the IRS concluded that the terms of the operating agreement created a second class of stock. This was the case even though the LLC elected S status at the time of its formation. Thus, if all parties contributed capital to the entity pro rata in accordance with their percentage interest in the LLC and all allocations of income were made pro rata to the members, then presumably the dollar figures that the members ultimately were entitled to through ordinary or liquidating distributions would be identical. Although the letter ruling does not describe the relative contributions by the parties, the IRS appears to have concluded that the mere existence of the partnership provisions described above in the operating agreement caused the LLC to have a second class of stock — regardless of whether any real differences in economic entitlement existed.
If a second-class-of-stock issue exists, it may be possible to obtain Sec. 1362(f) relief for an inadvertently invalid S election or an inadvertent termination of an initially valid election from the IRS through the private letter ruling process. However, that relief generally must be sought at the time the issue is discovered.
Second class of stock not created by mixed-use opportunity fund: The law known as the Tax Cuts and Jobs Act (TCJA)5 established the opportunity zone program under new Sec. 1400Z-1. Under this regime, a taxpayer that realizes an eligible capital gain prior to Dec. 31, 2026, may defer federal income tax on that gain, or a portion of it, by investing the amount of the gain, or a portion of it, in a qualified opportunity fund (QOF). If the amount invested in a QOF exceeds the amount of eligible gain, then the taxpayer may have a nonqualifying investment for the amount of gain in excess of eligible gain invested in the QOF and a qualifying investment for the amount of eligible gain invested in the QOF. This is referred to as a "mixed-fund" investment, and separate tracking may be required between the nonqualifying and qualifying portions of the QOF.
Regulations. Section 1.1400Z2(b)-1(c)(7)(iv), which became effective in March 2020, addresses an S corporation operating a mixed-funds investment in a QOF. Under the regulation, if different blocks of stock are created for separate qualifying investments to track basis in such qualifying investments, the separate blocks are not treated as different classes of stock for purposes of S corporation eligibility under Section 1361(b)(1).
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