Change Effective Date of S Corp Regs to Avoid Unfairness, Firm Says

December 23, 2019

CC:PA:LPD:PR (REG-131071-18)
Room 5203
Internal Revenue Service
P.O. Box 7604,
Ben Franklin Station
Washington, DC 20044

Re: Comment to the Proposed Regulations Concerning Eligible Terminated S Corporations

To Whom it May Concern:

This letter is submitted in response to the request for comments regarding the proposed regulations concerning Eligible Terminated S Corporations (the “Proposed Regulations”). Our comment relates specifically to the impact of the rule change to proposed regulation section 1.1377-2(b), as that change applies to distributions with respect to shares that were transferred to new shareholders after the termination of S Corporation status, but prior to the publication of the Proposed Regulations. This rule change eliminates the last sentence of existing final regulations section 1.1377-2(b) which currently reads as follows:

The special treatment under section 1371(e)(1) of distributions of money by a corporation with respect to its stock during the post-termination transition period is available only to those shareholders who were shareholders in the S corporation at the time of the termination. (emphasis added).

This sentence is commonly referred to as the “no-newcomer rule” and for purposes of this letter shall be subsequently referred to as the “Deleted Sentence”. It operates to cause the allocation of distributions from the accumulated adjustment account (AAA) to apply only to distributions made to persons who were shareholders on the date that S Corporation status terminated. As a result, distributions to persons who became shareholders after the termination date (i.e. distributions to newcomers) could not be allocated to the AAA.

We understand that the intent for removing the no-newcomer rule is to promote the policy objectives of easing the transition of former S corporations to full C corporation status, reducing the administrative burden on Eligible Terminated S Corporations (“ETSC”) and avoiding the complexity that would result from requiring ETSCs to report distributions disparately depending on the recipient. However, we believe that the non-application of the no-newcomer rule to distributions with respect to shares that were transferred prior to the publication of the Proposed Regulations (or pursuant to binding contracts entered into prior to that date) would, in many cases, have the unintended effect of altering the reasonably anticipated, bargained-for, economic results of any such share transfers (adversely impacting the transferor in favor of the transferee).

Distributions allocated to AAA are, as a general rule, more valuable to the recipient, as compared to transfers that are allocated to earnings and profits (particularly in the case of individuals who are not entitled to corporate benefits such as the dividends received deduction). Thus, in the case of share transfers negotiated prior to the announced elimination of the no-newcomer rule, the parties would have reasonably expected that the transfer would not entitle the transferee to any tax benefit associated with the corporation's AAA, with any such benefit being retained by the transferor. As a result, the bargained-for price for the transferred shares would not reflect any tax benefit associated with the AAA. The elimination of the no-newcomer rule after such a share transfer would have the effect of transferring value (i.e. the tax benefit associated with the AAA) from the transferor to the transferee for no consideration, contrary to the reasonable expectation of the parties when the transfer price was bargained for and solidified. The issue is further exacerbated when the transferor retains an interest in the corporation.

For instance:

If Shareholder A owned 100% of ETSC and sold 40% to Shareholder B, the sales price would have been set in accordance with the Deleted Sentence providing that Shareholder A would solely be entitled to future AAA distributions via their 60% retained interest (which would be equitable in that they were the party that would have been subject to U.S. federal income tax as the AAA account was built). Similarly, if ETSC instead issued new shares to Shareholder B, diluting Shareholder A, the issue price would have been set without an adjustment for the ensuing tax benefit.

This unintended result can be avoided by means of a change in the effective date for the Proposed Regulations. The effective date that is presently included in the Proposed Regulations reads as follows:

Section 1.1377-2 generally applies to taxable years beginning after [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER], however, corporations may choose to apply the rules in §§1.316-2, 1.481-5, 1.1371-1, 1.1371-2, and 1.1377-2 in their entirety, to the extent applicable, to taxable years that began on or before [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER] and with respect to which the period described in section 6511(a) has not expired. If the corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently. For taxable years beginning on or before [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER], see §1.1377-2(b) as contained in 26 CFR part 1, revised April 1, 2019.

We recommend that the effective date language be changed to read as follows:

Section 1.1377-2 generally applies to taxable years beginning after [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]. However, notwithstanding the last sentence of subsection (b), for corporations whose shares were transferred pursuant to a binding commitment entered after the termination of S Corporation status, but prior to [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]; allocations of the accumulated adjustment account (if any) under sections 1371(e)(1) and/or 1371(f) are available only to those shareholders who were shareholders in the S corporation at the time of the termination, unless all such shareholders that still retain ownership in such corporation consent to the election to apply 1.1377-2 in accordance with final regulations. In the case where no shareholders referred to in the preceding sentence retain such ownership, then subsection (b) shall apply in its entirety. Further, corporations may choose to apply the rules in §§1.316-2, 1.481-5, 1.1371-1 and 1.1371-2 in their entirety, to the extent applicable, to taxable years that began on or before [DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER] and with respect to which the period described in section 6511(a) has not expired. All shareholders of the corporation must report consistently in accordance with the forgoing provisions of this paragraph.

Alternatively, a separate subsection or paragraph may be added regarding the choices / elections discussed above but it should be clear that the shareholders that were in place at the time of the termination should have the authority on this decision (similar to the requirement where the majority of shareholder in a corporation must elect for S-Corporate treatment or termination), which will prevent a scenario where a newcomer (or newcomers) that acquires a majority stake in a the ETSC and would be able to control the decision.

We appreciate your consideration of this concern and would welcome the opportunity to meet with the staff from Treasury or the IRS to discuss this issue in connection with the implementation of the Proposed Regulations. If you have any questions regarding these comments, or if we can provide further information with respect to these comments, please do not hesitate to contact Kenneth Dettman at (305) 704-6691.

Respectfully submitted,

Kenneth Dettman
Managing Director
Alvarez & Marsal Taxands, LLC
Miami, FL