S corporations in New Hampshire are generally created from an LLC that chooses to file as an S corporation under the “check the box” regulations. While there is a litany of benefits to forming your S corporation with an LLC, from preferential treatment under NH I&D taxes to charging order protection, there are a couple of traps that you need to look out for that may make your S election entirely invalid, even if you are otherwise operating your business in a compliant manor.
The issue stems from boiler plate LLC language, drafted under the assumption you will operate as a partnership, that creates the implication of multiple classes of stock and disproportionate distributions - something that immediately disqualifies any business from electing S corporation status. In the event the S election is invalid the default treatment in this case would be as a C corporation, exposing the shareholders to substantially different tax treatment than what was originally intended, reaching back to formation of the S corporation.
Generally, the IRS has taken a relatively lenient approach to ineffective S elections, however coming to such a resolution may be expensive, time consuming and historically even escalated all the way to requiring a private letter ruling from the IRS national office costing tens or hundreds of thousands of dollars. While things don’t always escalate to this level of severity, the cost of correcting the issue proactively is infinitely smaller than dealing with it during an audit.
IRS Rev. Proc. 2022-19, which appears in the Internal Revenue Bulletin 2022-41 for October 11, 2022, provides procedures that allow S corporations and their shareholders to automatically resolve some of the most common issues with S corporation operating agreements. At a rather dense 29 pages there is a lot of superfluous information that isn’t going to impact the vast majority of taxpayers so we are just going to review the highlights.
Generally, the IRS has taken a relatively lenient approach to ineffective S elections, however coming to such a resolution may be expensive, time consuming and historically even escalated all the way to requiring a private letter ruling from the IRS national office costing tens or hundreds of thousands of dollars. While things don’t always escalate to this level of severity, the cost of correcting the issue proactively is infinitely smaller than dealing with it during an audit.
IRS Rev. Proc. 2022-19, which appears in the Internal Revenue Bulletin 2022-41 for October 11, 2022, provides procedures that allow S corporations and their shareholders to automatically resolve some of the most common issues with S corporation operating agreements. At a rather dense 29 pages there is a lot of superfluous information that isn’t going to impact the vast majority of taxpayers so we are just going to review the highlights.
The core point of Rev. Proc. 2022-19 that I think will be relevant to most taxpayers is Section 2.03(6)(b) - Non-identical governing provisions. The IRS states:
“If an entity files an S election when it has more than a single class of stock, the entity does not meet the requirements to be an S corporation and its attempted election is invalid.”
This is where the boiler plate LLC language may become an issue. Many boiler plate LLC agreements provide a provision that “liquidating distributions will be made in accordance with capital accounts” – this creates the implication that non-prorata distributions could be made, indicating a second class of stock. This interpretation is further reinforced in Section 3.02 - Governing Provisions That Provide for Identical Distribution and Liquidation Rights:
“As outlined in section 2.03(2) of this revenue procedure, § 1.1361-1(l)(2)(i) provides that a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights.”
“If an entity files an S election when it has more than a single class of stock, the entity does not meet the requirements to be an S corporation and its attempted election is invalid.”
This is where the boiler plate LLC language may become an issue. Many boiler plate LLC agreements provide a provision that “liquidating distributions will be made in accordance with capital accounts” – this creates the implication that non-prorata distributions could be made, indicating a second class of stock. This interpretation is further reinforced in Section 3.02 - Governing Provisions That Provide for Identical Distribution and Liquidation Rights:
“As outlined in section 2.03(2) of this revenue procedure, § 1.1361-1(l)(2)(i) provides that a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights.”
The operating agreement is a binding legal document, and while distributions may not have been made on anything other than a prorata basis, having the wrong language in your S corporations’ governing document would technically invalidate your S election.
While the IRS seems to have little interest in hunting down every invalid S election based on minor technicalities, correcting the issue now is by far and away the best option. Rev. Proc. 2022-19 provides a method for retroactively remediating the issue if you find yourself with a problematic operating agreement. The difficulty of the steps needed to correct the issue largely depends on how many members you have had since the inception of the return. If you are a founding member of the business, the issue has not already been raised by the IRS, and you have always filed your 1120-S tax return timely, remedy may be surprisingly affordable.
The basic procedures for correcting non-identical governing provisions are found in Section 3.06 Procedures for Retroactively Correcting One or More Non-Identical Governing Provisions and are summarized at a very basic level as follows:
Eligibility:
While the IRS seems to have little interest in hunting down every invalid S election based on minor technicalities, correcting the issue now is by far and away the best option. Rev. Proc. 2022-19 provides a method for retroactively remediating the issue if you find yourself with a problematic operating agreement. The difficulty of the steps needed to correct the issue largely depends on how many members you have had since the inception of the return. If you are a founding member of the business, the issue has not already been raised by the IRS, and you have always filed your 1120-S tax return timely, remedy may be surprisingly affordable.
The basic procedures for correcting non-identical governing provisions are found in Section 3.06 Procedures for Retroactively Correcting One or More Non-Identical Governing Provisions and are summarized at a very basic level as follows:
Eligibility:
- The corporation has not made a disproportionate distribution to an applicable shareholder
- Form 1120-S was timely filed for all years it was required
- Before any non-identical governing provision is discovered by the IRS, all of the requirements of this revenue procedure are satisfied.
- Revise the offending governing provision
- A Corporate Governing Provision Statement
- retained by the taxpayer and available for inspection by the IRS on request
- Shareholder Statements for all shareholders who ever received a K-1 from the S corporation
- retained by the taxpayer and available for inspection by the IRS on request
The most difficult step of the relief procedures is going to be obtaining the shareholder statements for all prior shareholders. In an ideal scenario all shareholders are current shareholders; in a worst case scenario prior shareholders left on negative terms and need significant prodding to provide the statement.
One of the last positions you ever want to be in is arguing with the IRS on whether or not you are actually an S corporation. According to this revenue procedure, the IRS estimates the historical total monetized burden of correcting this issue, via a private letter ruling, at about $190,000. The estimated time to become compliant under the retroactive relief now provided is 10 hours, reducing the burden on taxpayers by a substantial margin.
Given the ease of retroactive correction under these new Revenue Procedures we strongly encourage anyone with an S corporation to reach out to a qualified professional and seek a review of the operating agreement. While we provided the most common offending language here, certain other less common provisions may raise similar concerns. There may have been an argument to let sleeping dogs lie in the past, however now it would be foolish to continue to ignore such relief provisions.
One of the last positions you ever want to be in is arguing with the IRS on whether or not you are actually an S corporation. According to this revenue procedure, the IRS estimates the historical total monetized burden of correcting this issue, via a private letter ruling, at about $190,000. The estimated time to become compliant under the retroactive relief now provided is 10 hours, reducing the burden on taxpayers by a substantial margin.
Given the ease of retroactive correction under these new Revenue Procedures we strongly encourage anyone with an S corporation to reach out to a qualified professional and seek a review of the operating agreement. While we provided the most common offending language here, certain other less common provisions may raise similar concerns. There may have been an argument to let sleeping dogs lie in the past, however now it would be foolish to continue to ignore such relief provisions.
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