It is well known that stock issued by an S corporation, which does not pay corporate taxes because it passes its taxable income, losses, credits, and deductions to its shareholders, is ineligible for the qualified small business stock (QSBS) exclusion under Section 1202 of the tax code. However, until recently, it remained unclear whether stock issued by a corporation that ended its S election would remain eligible for this tax benefit.
In October, a private letter ruling from the IRS proposed a solution. The ruling suggests that, if an S corporation terminates its election on or before the date that the stock is issued, the stock is considered to be issued by a C corporation and could be eligible for the QSBS exclusion, assuming all other criteria under Section 1202 are satisfied.
This indicates a significant opportunity for S corporations that wish to issue QSBS midyear. Moreover, if an S election is accidentally ended, there is a silver lining: the stock could potentially qualify for the QSBS exclusion. With potential exclusions of up to $500 million given the $50 million gross asset cap stipulated by Section 1202(d), considering the QSBS exclusion could be crucial for decision-making between S corporation and C corporation status when forming and disposing of a closely held corporation.
In the October ruling, an S corporation that decided to issue a second class of stock, breaking Reg. 1.1361-1(l)(1)‘s rules, did not negatively impact the IRS’s final conclusion. Instead, the IRS concluded that the company had a qualified trade or business under Section 1202. Furthermore, the Reg. 1.1362-2(b)(2) legal framework seems to imply that if an S corporation no longer adheres to the small business corporation criteria, its S election is terminated as of the date of the disqualifying event, and it reverts to a C corporation for federal income tax purposes.
A few possible conditions can trigger the termination of a corporation’s S status. They include 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; not filing the S election timely, and not securing S election signatures from spouses in states with community property.
Once a corporation terminates its S status, regaining that status is not possible until four taxable years after the taxable year of termination, unless the IRS permits it under Section 1362(g). Thus, it could be argued that as 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 when it issued the stock, making it eligible for QSBS treatment.
However, the IRS limited its ruling to analysis under Section 1202(e)(3), resulting in differing interpretations amongst practitioners. Therefore, depending on the situation, the duty of consistency may influence one’s ability to claim a QSBS exclusion. Current findings, like the US Tax Court’s decisions in Garavaglia v. Commissioner and Coldiron v. Commissioner, provide both beneficial and detrimental examples of how the duty of consistency might affect one’s S election for these purposes.
Given the increasing frequency of S election issues in closely held corporations, practitioners should be aware of alternate strategies to circumvent S election issues during diligence and negotiations. The private letter ruling could serve as a guide for certain corporations that have unintentionally invalidated their S election. They may even discover they are “falling upward” by accepting their new status as a C corporation, which could potentially save them millions in taxes through the QSBS exclusion.
The full article, authored by Zachary M. Nolan, Warren J. “Skip” Kessler, and Daniel Cousineau, offers more in-depth analysis of the issue.