IRS Rev. Proc. 2022-19: Relief for S Corporation Owners

Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.


BROOKS NELSON: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today's topic is some much-welcome relief for S corporations, primarily related to inadvertent drafting errors in organizational documents. The IRS recently released Revenue Procedure 2022-19 to address these situations in an automatic manner.

BROOKS NELSON: We'll talk about this relief, where it can work best, where we'll see it most often, and how to comply. We'll also address a few other issues specific to S corporations.

BROOKS NELSON: Joining the conversation today is Barry Weins, director with the firm's National Tax Practice and a member of the firm's Tax Transaction Advisory team. Hello, Barry.


BARRY WEINS: Good, Brooks. How are you doing?


BROOKS NELSON: I'm here in Richmond. We're not at 75 degrees today, but we're warmer than a few days ago. Barry, where are you calling from?


BARRY WEINS: I'm here in sunny Tampa. We're going to be about mid-70s.


BROOKS NELSON: And as always, joining me is Sarah McGregor from Greenville. How's life treating you, Sarah?


SARAH MCGREGOR: Life is good, Brooks. Looking forward to the New Year, the bowl games, and what's next.


BROOKS NELSON: For the last 20 years, there's been a huge increase in S corporations in our practice. Going back to when they first came in, LLCs and partnerships were the predominant default entity for small business owners, but more companies began making S elections to address self-employment tax. Today, there are more S corporations than any other entity.

BROOKS NELSON: One age-old issue with S corporations is termination through technical defaults. Many of these technical defaults are inadvertent and arise from boilerplate language in governing documents. These issues also come up frequently in due diligence, especially with the uptick in acquisitions of closely held businesses in the private equity space.

BROOKS NELSON: The IRS released Revenue Procedure 2022-19, which on the surface provides exciting relief. There are nuances, and we'll discuss what the revenue procedure offers versus the traditional cure of obtaining private letter rulings. Barry, why is it important to maintain proper qualification as an S corporation, and what are the ramifications if you don't?


BARRY WEINS: If you intended an entity to be an S corporation, you set it up to accomplish specific tax goals, primarily to avoid the double level of tax associated with C corporations. S corporations are flow-through entities, and inadvertent foot faults can cause you to lose that treatment and become a C corporation, which raises significant tax consequences.

BARRY WEINS: Maintaining qualification preserves the planning you've put in place. Losing S status can result in tax inside the company and tax when distributions are made, defeating the purpose of electing S corporation status.


BROOKS NELSON: What common issues cause S corporations to seek IRS relief?


BARRY WEINS: There are two main areas. The first involves the original S election: did everyone sign, was it properly signed and filed on time? The IRS has issued several revenue procedures over the last decade to help correct those foot faults, such as issues in community property states where a spouse didn't sign.

BARRY WEINS: The second area concerns governing documents. Especially with LLCs that elect to be taxed as S corporations, you often see standard LLC language intended for partnerships, including allocations and distributions based on capital accounts. Poor or sloppy drafting can leave provisions that create a potential second class of stock, which violates S corporation requirements. These provisions are usually inadvertent boilerplate language, and Revenue Procedure 2022-19 targets this second set of issues.


BROOKS NELSON: To restate, you may have made an S election and operated as an S corporation for years, but later discover a foot fault that could reclassify you as a C corporation. The tax costs can be prohibitive, and until now many sought private letter rulings to cure these issues. How expensive and time consuming can PLRs be?


BARRY WEINS: Private letter rulings can cost around $50,000 for even simple matters and typically take a year or more, sometimes significantly longer. Revenue Procedure 2022-19 aims to provide an alternative to the PLR process.


BROOKS NELSON: Sarah, can you provide background on how this revenue procedure came about?


SARAH MCGREGOR: I served on the AICPA's S-Corporation Tax Resource Panel a few years ago, and we learned the IRS was inundated with letter ruling requests for the same recurring issues. These requests often arose when an S corporation was about to be involved in a transaction and the buyer wanted assurance the S election was intact.

SARAH MCGREGOR: The IRS was spending significant resources on these requests, which typically confirmed the historical tax reporting but did not change the underlying facts. Initially, the IRS announced informally it would not rule on these areas, which created uncertainty in the tax professional community. Rolling forward, Revenue Procedure 2022-19 officially states the IRS will not respond to PLR requests in these areas and provides a process to correct qualifying issues.

SARAH MCGREGOR: If appropriate corrections are made and there was no intent to avoid tax, the revenue procedure provides guidelines. In some cases the IRS requires filing information; in other cases it requires retaining documentation in the corporate records.


BROOKS NELSON: Barry, what are the key points and circumstances the revenue procedure addresses?


BARRY WEINS: It addresses six specific items related to potential disqualification of S corporations. Five of those items have been addressed before in prior guidance. The main change in this revenue procedure concerns non-identical governing provisions, where distributions or liquidation rights may not be equal per share. These provisions often appear in LLC agreements and can create questions about a second class of stock.

BARRY WEINS: Revenue Procedure 2022-19 lays out steps and qualifications for curing non-identical governing provisions, and that's its primary focus.


BROOKS NELSON: How does an S corporation comply with the revenue procedure?


BARRY WEINS: To be eligible, you must meet certain requirements. First, you must have one of these non-identical governing provisions. Second, the IRS must not have discovered the issue. You also cannot have made disproportionate distributions, meaning distributions must be pro rata to ownership interests.

BARRY WEINS: If discrepancies exist in the past, correct them so you can attest you did not make disproportionate distributions. Timing is flexible; for example, distributing $10,000 to one shareholder and $10,000 to another the next day is acceptable.

BARRY WEINS: All tax returns for the years in question must have been timely filed, generally by the due date with extensions. If you filed an extension and missed the extended due date, you are late and may not qualify. If you did not file an extension but filed by the original due date or otherwise met filing requirements, you should qualify.

BARRY WEINS: The second step is preparing a governing-provision statement. This resembles the documentation process for a PLR. You must identify the entity, the period of the S election, and all applicable shareholders, meaning anyone who was a shareholder at any time when the governing provisions were in effect.

BARRY WEINS: If a former shareholder is involved, you need their signature on the required shareholder statement. You must describe the facts: how the provisions arose, how they were discovered, what corrections were made, how quickly you corrected them, and demonstrate you acted reasonably and in good faith. Shareholders and officers must attest to these facts, and you must fix the governing document when you discover the issue. Then you assemble the package and retain it in the corporate records in case the IRS requests it.


BROOKS NELSON: How do you think this will be perceived in the M&A community?


BARRY WEINS: I'm skeptical it will fully replace buyer concerns about risk. Buyers worry about the IRS rejecting the relief if they believe the corrections were not made in good faith, and the revenue procedure does not guarantee the IRS will accept the cure. It provides comfort to sellers, but buyers may still prefer transactional structures, such as F reorganization transactions, where the historical S corporation entity remains with the sellers.

BARRY WEINS: Operationally, however, it's beneficial for S corporations to correct issues and have the comfort of this procedure on a go-forward basis.


BROOKS NELSON: As we enter preparation season for 2022 calendar year returns, Sarah, what other issues should S corporations and shareholders consider?


SARAH MCGREGOR: Schedule K-2 and K-3 reporting of international activity began for 2021 returns, so this will be the second year of that reporting. The IRS has streamlined requirements for who must file and clarified a domestic activity exception. If an S corporation and its shareholders have minimal international activity, it may be easier to avoid preparing Schedule K-2 and issuing K-3s. The instructions are not finalized yet, but guidance is coming.

SARAH MCGREGOR: The IRS continues to focus on two areas prone to missteps: first, whether distributions are taxable to shareholders because they exceed stock basis or come from accumulated earnings and profits from when the entity was a C corporation; and second, whether shareholders are claiming losses and deductions in excess of their basis in S corporation stock. These areas remain enforcement priorities.


BROOKS NELSON: Final comments. Barry, any overall words of wisdom about Revenue Procedure 2022-19?


BARRY WEINS: Anyone with one of these issues should consider using the revenue procedure regardless of transactional considerations. The longer you let a potential problem sit, the greater the risk, because one eligibility requirement is that the IRS has not discovered the issue. Every S corporation should review its governing documents and, if problems exist, follow the revenue procedure to correct them. This is particularly important if an LLC has elected S corporation status. Review the organizing documents and ensure they are current.


SARAH MCGREGOR: Since we're preparing 2022 tax returns, now is a great time to revisit all issues and confirm qualification for S corporation status. If Revenue Procedure 2022-19 resolves any issues, take advantage of it.


BROOKS NELSON: That's a wrap on this discussion of S-corporation relief under Revenue Procedure 2022-19. It provides a path for some S corporations to correct technical errors and organizational document issues. Quick reminder: we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.

BROOKS NELSON: Also, feel free to reach out to our expert, Barry Weins. Check the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics.

BROOKS NELSON: This concludes today's podcast. Please like, share, and subscribe.

BROOKS NELSON: Thank you, Barry, and thank you to our listeners for spending your time with us. Let's call it a day and go forth in peace.


BARRY WEINS: Thank you.


SARAH MCGREGOR: Thank you.