Firm Welcomes Rejection of ‘No-Newcomer’ Rule in S Corp Regs

December 18, 2019

CC:PA:LPD:PR (REG-131071-18)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue NW
Washington, DC 20224

Re: Comments to REG-131071-18, Eligible Terminated S Corporations

To Whom It May Concern:

Miller & Chevalier Chartered respectfully submits these comments with respect to the Notice of Proposed Rulemaking, REG-131071-18, Eligible Terminated S Corporations, as published in the Federal Register on November 7, 2019 (the “Proposed Regulations”).¹ The Proposed Regulations provide much needed guidance regarding the rules under section 1371(f) of the Internal Revenue Code (the “Code”) relating to distributions of money by an eligible terminated S corporation (“ESTC”) after the post-termination transition period (“PTTP”).² Miller & Chevalier appreciates the time and resources that the Treasury Department and the Internal Revenue Service (“IRS”) have dedicated in developing the Proposed Regulations and appreciates the opportunity to provide these written comments to this important guidance.

Special Treatment During the PTTP Under Section 1371(e)

If a corporation's S election terminates, section 1371(e) permits tax-free distributions of cash to the shareholders of the resulting C corporation during the corporation's PTTP, which is generally the one-year period after the S election terminates.³ Specifically, during the PTTP, a cash distribution by the former S corporation with respect to its stock is applied against and reduces the adjusted basis of the recipient shareholder's stock, to the extent that the amount of the distribution does not exceed the corporation's accumulated adjustments account (“AAA”), which measures the S corporation's income that has been previously taxed to its shareholders. As such, the former S corporation is generally given a one-year grace period to distribute its AAA to its shareholders. Qualifying distributions are tax-free to the extent of the recipient's basis in its stock and then are taxable as capital gain to the extent the distribution exceeds the recipient's basis in that stock. Therefore, distributions during the PTTP are generally preferable to a distribution by a C corporation that is taxable under section 301, which are treated as first coming out of the corporation's earnings and profits (“E&P”) as a taxable dividend.

Extension of Special Treatment During the ETSC Period by Section 1371(f)

Congress recognized that the changes enacted by the Tax Cuts and Jobs Act,⁴ including the significant decrease in the corporate tax rate from 35% to 21%, might cause business owners to want to transition from S corporations to C corporations.⁵ To ease this transition, Congress enacted section 1371(f), which extends the period during which the former S corporation can make distributions to its shareholders from AAA generated when the corporation was an S corporation.⁶ Because distributions during the PTTP are required to be made in cash, prior to the enactment of section 1371(f), many former S corporations were unable to distribute their BA. to their shareholders during the PTTP. Section 1371(f) only applies to an ETSC, which, in turn, requires (i) that the revocation of the S election occurred during the two-year period ending on December 22, 2019, and (ii) that the owners of the shares of the S corporation were the same (and in identical proportions) on both December 22, 2017 and the effective date of the revocation.⁷ Therefore, the window of time to qualify as an ETSC is rapidly closing. The Proposed Regulations helpfully clarify that a revocation of an S election is validly made during the 2-year period ending on December 22, 2019 even if the effective date of the revocation occurs after that date.⁸

Specifically, section 1371(f) provides that a distribution of money by a distributing ETSC following the PTTP is treated as coming out of such corporation's AAA or E&P in the same ratio as the amount of such AAA bears to the amount of the corporation's accumulated E&P. Unlike the PTTP, which generally terminates after one year, the ETSC period begins on the first day after the PTTP and expires when the ETSC's AAA balance is zero.⁹

Consideration and Rejection of the “No-Newcomer Rule” for the ETSC Period

Although section 1371(f) requires an identity of share ownership to qualify as an ETSC, prior to the enactment of the Proposed Regulations, it was unclear whether this identity of share ownership must be maintained during the ETSC period. The Treasury Department and the IRS explicitly considered and rejected a so-called “no-newcomer rule” that would limit recipients of qualified distributions for purposes of section 1371(f) to the shareholders of the S corporation at the time of revocation.¹⁰ We agree that such a narrow reading would be inconsistent with the intent of section 1371(f) and the legislative history underlying the enactment of section 1371(f). In this regard, the preamble noted that (i) by its terms, section 1371(f) does not require the recipients of qualified distributions to have been shareholders of the S corporation at the time of revocation, (ii) no part of the legislative history indicates a Congressional intent to impose such a limitation on such distributions, (iii) a no-newcomer rule would be inconsistent with Congressional intent to ease the transition of former S corporations to full C corporation status because such a no-newcomer rule would impede an ETSC's ability to exhaust its AAA, (iv) a no-newcomer rule also would impose an administrative burden on ETSCs and create complexity by requiring ETSCs to report distributions disparately depending on the recipient, and (v) a rule allowing newcomers would be more consistent with treating the AAA as a corporate-level account.¹¹ In light of these factors, the Treasury Department and the IRS rejected the no-newcomer rule with respect to the ETSC period.¹²

Under the Proposed Regulations, any shareholder of the former S corporation may receive distributions during the ETSC period, all or a portion of which may be sourced from AAA, without regard to whether such shareholders owned shares, or owned shares in the same proportion, on the date of the revocation of the corporation's S election.¹³ We agree with the conclusion in the preamble that such a result “would best implement the plain language of section 1371(f) and the policy objective of easing the transition of affected taxpayers from S corporation status to C corporation status.”¹⁴

Conforming Amendment of Treas. Reg. §1.1377-2 to Similarly Allow for Special Treatment Under Section 1371(e)(1) for New Shareholders During the PTTP

Importantly, the Proposed Regulations also contain a conforming amendment to Treas. Reg. § 1.1377-2 to similarly allow for new shareholders to receive distributions sourced from AAA during the PTTP such that the special treatment provided under section 1371(e)(1) will apply to all shareholders of the corporation without regard to their status on the date of the termination. In this regard, the preamble notes that the last sentence of Treas. Reg. § 1.1377-2(b) limits the special treatment provided under section 1371(e)(1) solely to those shareholders who were shareholders of the S corporation at the time of termination or revocation of its S election.¹⁵

The Treasury Department and the IRS determined that because the rules pertaining to the PTTP and to the ETSC period serve the similar objective of easing the transition from S corporation status to C corporation status, the rules regarding newcomers should be consistent.¹⁶ Therefore, based on the rationale for rejecting a no-newcomer rule for the ETSC period, the Treasury Department and the IRS determined that a no-newcomer rule should also not apply to the PTTP.¹⁷ Therefore, the Proposed Regulations propose to delete the last sentence of Treas. Reg. § 1.1377-2(b) to allow the special treatment under section 1371(e)(1) to apply to all shareholders during the PTTP.

Miller & Chevalier Supports the Rejection of the No-Newcomer Rule for the ETSC Period and the PTTP

Miller & Chevalier believes that the Proposed Regulations' rejection of the no-newcomer rule during the ETSC period and the clarification for distributions during the PTTP reach the correct result. The grace period allowed under section 1371(e)(1) and 1371(f) for distributions of AAA should apply to all shareholders of the corporation, including new shareholders. As noted throughout the preamble, the rejection of the no-newcomer rule in both contexts is consistent with the statutory language of these provisions and their underlying legislative history. Furthermore, as also noted throughout the preamble, the rejection of the no-newcomer rule is consistent with the policy objective of easing the transition from S corporation status to C corporation status. Therefore, Miller & Chevalier respectfully requests that the rejection of the no-newcomer rule for the ETSC period and the PTTP be retained in the Proposed Regulations when finalized.

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Thank you in advance for your consideration of this comment letter. We appreciate the opportunity to submit this comment letter and would welcome the opportunity to meet with the Treasury Department and the IRS to discuss it in greater detail or to answer any questions that you may have.

Respectfully submitted,

Marc J. Gerson

David W. Zimmerman

Miller & Chevalier Chartered
Washington, DC

cc:
The Honorable David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury
Jeffrey Van Hove, Senior Advisor to the Assistant Secretary (Tax Policy), Department of the Treasury
Krishna Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
The Honorable Charles Rettig, Commissioner, Internal Revenue Service
The Honorable Michael Desmond, Chief Counsel, Internal Revenue Service
Holly Porter, Associate Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service