Accounting Firm Seeks Changes to Regs on Eligible Terminated S Corps

December 20, 2019

CC:PA:LPD:PR (Reg-131071-18)
Courier's Desk
Internal Revenue Building
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Comments on Proposed Amendments to Regulations under Sections 481 and 1377 and Proposed Regulations under Section 1371

Dear Sir:

On November 7, 2019, the Treasury Department and Internal Revenue Service issued proposed amendments to regulations under sections 481 and 1377 along with proposed regulations under section 1371 of the Internal Revenue Code (“Code”) that would affect certain “eligible terminated S corporations” (ETSCs). We commend the drafters on their work and applaud the approach they have outlined with respect to the implementation of the ETSC proration required by section 1371(f).

Our comments in this letter are focused on a very narrow issue involving the definition of an ETSC, in particular the share ownership requirement as described in prop. reg. 1.481-5(b)(3). As we explain more fully below, we believe that language in the proposed regulations may inadvertently, and inappropriately, deny ETSC status to certain entities that experienced an ownership change between the effective date of their revocations and the date the elections were filed. We appreciate the opportunity to raise this issue and hope that you will consider our suggested change to ensure that these entities are not inadvertently denied ETSC status.

These comments represent the view of RSM US LLP (“RSM”), the fifth largest public accounting firm in the United States. RSM focuses principally on serving clients in the middle market, which accounts for more than a third of US employment and about 40 percent of the U.S. gross domestic product. RSM has prepared and submits these comments on its own behalf. We do have clients that would be affected by the issue we raise.

Background

Congress recognized that changes enacted as part of the Tax Cuts and Jobs Act (TCJA) might significantly affect an existing S corporation's desire to retain its subchapter S status. As Treasury outlined in the preamble to these proposed regulations, Congress determined that “it is important to provide rules to ease the transition from S corporation to C corporation for the affected taxpayers” because “taxpayers that previously elected to be taxed as S corporations may prefer to instead be taxed as C corporations.” H. Rept. 115-409, at 256 115^th Cong. 1^st Sess., (Nov. 14, 2017) House Report.

To help ease the transition, Congress enacted section 1371(f), which provides that for ETSCs, distributions of money following the post-termination transition period would be charged to the company's accumulated adjustments account (AAA) and its accumulated earnings and profits (AE&P) in the ratio that those accounts bear to each other.

Eligible Terminated S Corporations

The special distribution provisions outlined in section 1371(f) only apply to ETSCs. Newly enacted section 481(d) defines an ETSC as a C corporation which:

We focus the remainder of our discussion on the third item — in particular, the interpretation of the date the revocation is made.

Proposed Regulations

Proposed reg. 1.481-5(b) defines an ETSC in a manner that mirrors the statute. In particular, it requires that in order to be an ETSC, the owners of the corporate shares must be the same (and in identical proportions) on both December 22, 2017, and “the day on which the Revocation is made.”

The proposed regulations clarify this guidance in three examples. We highlight two of those examples here, starting with prop. reg. 1.481-5(d), example 1. That example describes a corporation that filed its revocation election on March 15, 2019, to be effective January 1, 2019. When analyzing whether the corporation was an ETSC, the example indicates that the date the revocation election was filed (March 15, 2019), rather than its effective date (January 1, 2019), is the relevant date for purposes of assessing whether the company experienced a disqualifying ownership change.

The proposed regulations reiterate that conclusion in example 3. In that example, the corporation filed its revocation election on November 1, 2019, to be effective January 1, 2020. The example indicates, “Although the effective date of X's revocation of its S election (January 1, 2020) occurs after the conclusion of the 2-year period specified in paragraph (b)(2) of this section, it is irrelevant for purposes of determining whether the requirements of paragraphs (b)(2) and (3) of this section are satisfied.”

The examples are effectively indicating that the phrase “on the date the revocation is made” means “on the date the revocation is filed.” That interpretation would be welcome and helpful to a corporation that seeks to qualify for ETSC status by filing a prospective revocation for 2020. As such, that interpretation might be viewed as furthering Congress's desire to ease the transition from S corporation to C corporation status for additional taxpayers.

However, that interpretation would deny ETSC status to any corporation that experienced an ownership change during the period between the effective date of the revocation and its filing. For example, an S corporation that filed a revocation statement on March 15, 2018, to be effective January 1, 2018, would not be an ETSC under these proposed regulations if the company experienced an ownership change, no matter how incidental, between January 1, 2018, and March 15, 2018.

We respectfully suggest that denying such a corporation ETSC status would be:

We expand upon each of these considerations in the sections that follow.

Good Faith Effort

We recognize the significant burden imposed on Treasury following TCJA's enactment to provide guidance in numerous areas — most of which had far more significant implications than the one we discuss here. Nonetheless, this provision could have significant ramifications for taxpayers that filed retroactive revocation elections within the first 2 ½ months of their tax year. Although these proposed regulations provide much needed guidance, they are being released nearly two years after TCJA's enactment, which is well after most impacted corporations would have revoked their subchapter S elections. Those taxpayers were forced, with limited guidance, to make a good faith attempt to determine whether they would qualify as ETSCs. For many companies with significant AAA, ETSC status was critical.

The guidance these taxpayers had was scarce. In section 3204 of the House Bill, the House described the requirement with respect to ownership as follows:

“All of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.” H.Rept. 115-409, at 245 115^th Cong. 1^st Sess., (Nov. 14, 2017) House Report.

The Joint Committee on Taxation in its General Explanation of Public Law 115-97, prepared in December 2018, explained this as requiring that the C corporation “has all the same owners (and in identical proportions) on the date the S corporation election is revoked as on December 22, 2017.”

Beyond this, taxpayers had minimal additional guidance on which to lean.¹

We believe that it would be reasonable for a taxpayer to interpret the statute and accompanying guidance that references “the date the S corporation election is revoked” as meaning the date the revocation is effective. That interpretation would seem to be entirely consistent with the subchapter S election guidance in section 1362(b)(1). That section effectively provides that an election filed within the first 2 ½ months of the year is treated as made on the first day of the tax year.

The subchapter S revocation rules outlined in section 1362(d)(1) use different language, indicating that revocations made on or before the 15^th day of the third month of the tax year are treated as being effective on the first day of the year. But that language would seem to hold no more relevance than would the 1362(b)(1) language when trying to determine when an election would be made for purposes of section 481(d). Furthermore, if Congress had intended to treat the filing date as the date the revocation was made, it could have clearly stated so or alternatively referenced section 1362(d)(1).²

Congressional Intent

As we discussed earlier, Congress recognized that the changes enacted as part of TCJA might cause S corporations to reconsider their tax status, and Congress clearly was interested in easing the transition for those that wanted to revoke their subchapter S elections. For this reason, it seems appropriate that the regulatory provisions should reflect that intent and not deny section 1371(f) benefits to corporations that often were trying — sometimes within a very narrow window — to fit within these rules.³

It appears from the statutory language that Congress intended there be continuity of ownership in the C corporation formerly taxed as an S corporation in order to qualify for ETSC status. The logical period of continuity would seem to start on December 22, 2017, and run through the date the corporation is no longer an S corporation. That conclusion would be consistent with the existing continuity rule under reg. 1.1377-2(b), which only affords section 1371(e) treatment to those who were shareholders “at the time of the termination.”

However, the proposed regulations as drafted suggest that a corporation could have completely different owners when first taxed as a C corporation than was the case when it was taxed as an S corporation. This again is highlighted by example 3 of the proposed regulations where the corporation files its revocation request on November 1, 2019, to be effective January 1, 2020. The corporation could have completely new owners on January 1, 2020, the effective date it is first taxed as a C corporation, and still qualify as an ETSC. Compare this to the corporation that files its revocation request on March 15, 2018, to be effective on January 1, 2018. The owners on the corporation's first date being taxed as a C corporation, i.e., January 1, 2018, the effective date of the revocation, are nearly certain to be the same owners as on December 22, 2017. Yet the corporation would be denied ETSC status if there was an ownership change between January 1, 2018, and March 15, 2018. That result seems inconsistent with Congressional intent to ease the transition from S corporation to C corporation status.

Treating Similarly Situated Taxpayers Equally

Finally, we would question whether there is an abuse that the regulations prevent by focusing on the filing date. Consider the example of two otherwise identical corporations that experienced an ownership change on February 1, 2018. Assume that Corporation A revoked its subchapter S status on January 15 while Corporation B revoked its status on February 15 — both to be effective January 1, 2018. Except for one item, those entities would be in identical tax positions — both could be C corporations effective January 1, 2018; both could make distributions to their shareholders (both historic and new) that would qualify for PTTP treatment.⁴ The one difference would be Corporation A would be an ETSC while Corporation B would not. There does not appear to be policy reason why that disparate treatment would be desirable.

Conclusion

Given the lack of definitive guidance in the statute and the accompanying material, we believe that a reasonable interpretation of the relevant phase (i.e., the date the revocation is made) would include one that references the date the revocation was effective. For this reason, we believe that the regulations should be modified to provide that a revocation may be treated as made on the “effective” date the revocation, or alternatively that a revocation request with a retroactive effective date made pursuant to section 1362(d)(1)(C)(i) may be treated as made for purposes of section 481(d)(2)(B) on such effective date.

If the regulations are not modified in this manner, we nonetheless believe that taxpayers who took such a position prior to the effective date of these regulations should be afforded protection similar to that which was provided in reg. 1.1362-7 for taxpayers who took reasonable positions prior to the enactment of those regulations in final form. Taxpayers should not be concerned that their ETSC status will be challenged on this issue in a later year.

Once again, we commend Treasury and the IRS for their work on these proposed regulations and appreciate your consideration of our suggested changes. We would be pleased to discuss the comments with you or your staff if that would be helpful. If you would like to discuss please contact Ed Decker at Ed.Decker@rsmus.com or 515.281.9222.

Respectfully submitted,

Ed Decker

John Romano

RSM US LLP
Washington, DC