It's commonly understood that stock issued by an S corporation—which doesn't pay corporate taxes because it passes its taxable income, losses, credits, and deductions to its shareholders—is ineligible for the qualified small business stock exclusion under Section 1202 of the tax code.

But until recently, it's been unclear whether stock issued by a corporation that ended its S election qualifies for the tax break.

An IRS private letter ruling from October suggested that if an S corporation terminates its election on or before the date that the stock is issued, it's considered to be issued by a C corporation. Therefore, it could qualify for the QSBS exclusion, provided all other criteria under Section 1202 are met.

This now presents a significant opportunity for S corporations that want to issue QSBS midyear and highlights a strategic maneuver where intentionally ending an S election can make this QSBS exclusion available. Moreover, for those instances where an S election is inadvertently ended, there emerges a silver lining—the possibility that the stock could now qualify for the QSBS exclusion.

The QSBS exclusion allows for an exclusion equal to the greater of either $10 million or 10 times the adjusted basis of the taxpayer's QSBS. Given the $50 million gross asset cap stipulated by Section 1202(d), this framework allows a potential QSBS exclusion of up to $500 million.

Given these substantial benefits, the QSBS exclusion should be a key consideration for tax practitioners and taxpayers alike when deciding between S corporation and C corporation status when forming and disposing of a closely held corporation.

In the October ruling, a corporation made an S election to be treated as an S corporation, but it invalidated its S election by issuing a second class of stock, in violation of Reg. 1.1361-1(l)(1). This sequence of events didn't negatively affect the IRS's conclusion, and the agency concluded that the company had a qualified trade or business under Section 1202.

While the ruling doesn't offer a detailed explanation or discuss the legal basis for the IRS's position, the underlying legal framework for its conclusion would appear to be found in Reg. 1.1362-2(b)(2). It states that if an S corporation no longer meets the criteria for a small business corporation, its S election is terminated as of the date of the disqualifying event, causing it to revert back to a C corporation for federal income tax purposes.

As a result, a company's S corporation status should terminate on the day any one of the following requirements is violated:

  • Exceeding the limit of 100 shareholders
  • Including shareholders who are neither individuals nor certain specified trusts
  • Having a nonresident alien among its shareholders
  • Issuing more than one class of stock, which often arises due to disproportionate distributions or shareholder debt being reclassified as equity
  • Not filing the S election in a timely manner
  • Not securing S election signatures from spouses in community property states

Once a corporation terminates its S status, it can't regain that status until four taxable years after the taxable year of termination—unless the IRS permits it under Section 1362(g). It follows to reason that although the corporation in the private letter ruling made an S election on day one, it immediately violated its election and was treated as a C corporation at the time it issued the stock, and therefore eligible for QSBS treatment.

The IRS did limit its ruling to an analysis under Section 1202(e)(3), so practitioners' views may differ on how to interpret this guidance. We believe that the guidance, along with the S corporation regulations, supports the position that stock issued by an S corporation that has terminated its S election may qualify as QSBS under an appropriate set of facts.

Depending on the particular facts at hand, the duty of consistency may affect one's ability to claim a QSBS exclusion in these cases. There is a fair amount of uncertainty as to how the duty of consistency may apply to one's S election for these purposes, with existing guidance providing both helpful and hurtful examples.

The US Tax Court in Garavaglia v. Commissioner stated that neither the form chosen by a corporation "nor the duty of consistency usurps the failure of those companies to satisfy the strict requirements for electing subchapter S status." However, the court in Coldiron v. Commissionerheld that the duty of consistency required a company to be treated as an S corporation, even though it wasn't one, as a consequence of an improper deduction taken by the shareholders in previous years.

Given how common it is for S election issues to arise in a closely held corporation—as shown by the growth in tax insurance policies covering S corporation exposures—practitioners should be aware of alternative routes to plan around S election issues that arise during diligence and negotiations.

With the private letter ruling as a potential north star, certain corporations that have unintentionally invalidated their S election may discover they are inadvertently "falling upward" by embracing their status as a C corporation to benefit from the QSBS exclusion—which could potentially save millions in taxes.

Originally published by Bloomberg Law

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