SECTION 2. BACKGROUND — Internal Revenue Bulletin 2022-41

.01 Overview of S Corporations and QSubs .

(1) Definition of S corporation . Section 1361(a)(1) defines an “S corporation,” with respect to any taxable year, as a small business corporation for which an S election, under § 1362(a), is in effect for that year.

(2) Definition of small business cor- poration . Section 1361(b)(1) defines a “small business corporation” as a domestic corporation that is not an ineligible corporation (defined in § 1361(b)(2)) and that does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than 1 class of stock. (3) Definition of QSub . Section 1361(b) (3)(B) defines a “QSub” as a domestic corporation that is not an ineligible corporation if (i) an S corporation (parent S corporation) holds 100 percent of the stock of the corporation, and (ii) that parent S corporation elects to treat the subsidiary as a QSub.

(4) S election . Section 1.1362-6(a) (2) of the Income Tax Regulations sets forth procedural requirements pursuant to which a small business corporation makes an S election. Among those requirements, the small business corporation must timely file a completed Form 2553, Election by a Small Business Corporation. See Rev. Proc. 2013-30, 2013-36 I.R.B. 173 (providing a simplified method for taxpayers to request relief for late S elections).

(5) QSub election . Section 1.1361-3(a) and Notice 2000-58, 2000-2 C.B. 491, set forth procedural requirements for a parent S corporation to elect to treat one or more of its eligible subsidiaries as a QSub. Among those requirements, the parent S corporation must timely file a completed Form 8869, Qualified Subchapter S Subsidiary Election. See Rev. Proc. 201330 (providing a simplified method for taxpayers to request relief for late QSub elections).

(6) Ineffective or terminated S election . If a corporation is not eligible to elect to be taxed under subchapter S of the Code (for example, the corporation is not a small business corporation under § 1361(b)(1)), then the corporation’s S election never becomes effective. If a corporation makes a valid S election, generally its status as an S corporation (i) can be terminated by revocation of the election, and (ii) will be terminated (A) whenever the corporation ceases to be a small business corporation, or (B) whenever the passive investment income of the corporation exceeds 25 percent of gross receipts for three consecutive taxable years and the corporation has accumulated earnings and profits at the close of each of the three consecutive years. See generally § 1362(d).

(7) Ineffective or terminated QSub election . If a parent S corporation cannot make an effective QSub election because the subsidiary corporation is not eligible to be taxed as a QSub (for example, the required consent on Form 8869 is missing), then that corporation’s QSub election never becomes effective. If a parent S corporation makes a valid QSub election for its subsidiary, generally the subsidiary’s status as a QSub (i) can be terminated by revocation of the election, and (ii) will be terminated if (A) the S election of its parent S corporation is terminated, or (B) the subsidiary ceases to qualify as a QSub under § 1361(b)(3)(B). See gener- ally § 1.1361‑5(a)(1). In addition, a QSub election for a subsidiary terminates if the

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parent S corporation transfers 100 percent of the QSub stock, whether by sale or reorganization under § 368(a)(1)(A), (C), or (D) of the Code, to another S corporation in a transaction that does not qualify as a reorganization under § 368(a)(1)(F). See Rev. Rul. 2004-85, 2004-2 C.B. 189 (Situation 2).

.02 Section 1362(f) Relief for Inadver- tent Invalid Elections or Terminations .

(1) Overview . Section 1362(f) provides that if an S election under § 1362(a) or a QSub election under § 1361(b)(3) (B)(ii) by any corporation either (A) was not effective for the taxable year for which made (determined without regard to § 1362(b)(2)) by reason of a failure to meet the requirements of § 1361(b) or to obtain shareholder consents, or (B) was terminated under § 1362(d)(2) or (3) or § 1361(b)(3)(C), then, notwithstanding the circumstances resulting in that ineffectiveness or termination, that corporation will be treated as an S corporation or a QSub, as the case may be, during the period specified by the Secretary (as defined in § 7701(a)(11)(B) of the Code) if the three requirements set forth in § 1362(f)(2) through (4) are satisfied. First, the Secretary must determine that the circumstances resulting in the ineffectiveness or termination were inadvertent. See § 1362(f)(2). Second, no later than a reasonable period of time after discovery of the circumstances resulting in that ineffectiveness or termination, steps were taken either (A) so that the corporation for which the election was made or the termination occurred is an S corporation or a QSub, as the case may be, or (B) to acquire the required shareholder consents. See § 1362(f)(3). Third, the corporation for which the election was made or the termination occurred, and each person who was a shareholder in that corporation at any time during the period specified pursuant to § 1362(f), agrees to make such adjustments (consistent with the treatment of that corporation as an S corporation or a QSub, as the case may be) as may be required by the Secretary with respect to that period. See § 1362(f)(4).

(2) Legislative history . In enacting § 1362(f), Congress stated that, “[i]f the

[IRS] determines that a corporation’s subchapter S election is inadvertently terminated, the [IRS] can waive the effect of the

terminating event for any period if the corporation timely corrects the event and if the corporation and the shareholders agree to be treated as if the election had been in effect for such period.” S. Rep. No. 97-640, at 12 (Sept. 29, 1982). Congress “intend[ed] that the [IRS] be reasonable in granting waivers, so that corporations whose subchapter S eligibility requirements have been inadvertently violated do not suffer the tax consequences of a termination if no tax avoidance would result from the continued subchapter S treatment. In granting a waiver, [Congress] hoped that taxpayers and the government will work out agreements that protect the revenues without undue hardship to taxpayers.” Id .

(3) Section 1362(f) regulations . Section 1.1362-4(c) provides that a corporation may request invalid election or inadvertent termination relief by submitting a request for a PLR. See generally Rev. Proc. 2022-1, 2022-1 I.R.B. 1 (or any successor revenue procedure) (providing general instructions for requesting PLRs and determination letters). Section 1.1362-4(d) provides that the Commissioner may condition the granting of a PLR request on any adjustments that are appropriate. Section 1.1362-4(e) requires that the corporation and all persons who were shareholders of the corporation at any time during the time specified by the Commissioner consent to any adjustments that the Commissioner may require. Section 1.1362-4(f) provides that the status of a corporation after the terminating event or invalid election, and before the determination of inadvertence, is determined by the IRS. Inadvertent termination or inadvertent invalid election relief may be granted by the IRS retroactively (i) for all years for which the terminating event or circumstance giving rise to invalidity is effective, or (ii) only for the period in which the corporation became eligible for S corporation or QSub treatment.

(4) Frequent PLR requests for relief under section 1362(f) . The Associate Chief Counsel (Passthroughs and Special Industries) frequently receives requests for PLRs seeking relief under § 1362(f) to address a potential inadvertent invalid election or termination. For example, the Associate Chief Counsel (Passthroughs and Special Industries) receives PLR

requests seeking confirmation that specific agreements, distributions to shareholders, minor errors in filing elections, missing or lost confirmations, or inconsistent return filings do not invalidate an S corporation’s election or terminate the corporation’s status as an S corporation.

.03 Six Areas for Which Issues are Resolvable Without a PLR . Sections 2.03(1) through 2.03(6) of this revenue procedure describe the six areas for which issues are resolvable without a PLR, and for which this revenue procedure provides taxpayer assistance procedures. With regard to the sixth area described in 2.03(6) of this revenue procedure (addressing potential retroactive correction of non-identical governing provisions), the validity or continuation of a corporation’s S election is not affected in certain circumstances only if the corporation and its applicable shareholders (as defined in section 3.06(1)(a) of this revenue procedure) meet the requirements of section 3.06 of this revenue procedure.

(1) One class of stock requirement and governing provisions, including “princi- pal purpose” conditions .

(a) Overview . Pursuant to § 1361(b) (1)(D) and § 1.1361-1(l)(1), a corporation that has more than one class of stock does not qualify as a small business corporation. Section 1.1361-1(l)(1) provides generally that a corporation is treated as having only one class of stock if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

(b) Governing provisions . Section 1.1361-1(l)(2)(i) provides that the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable State law, and binding agreements relating to distribution and liquidation proceeds (collectively, governing provisions). A commercial contractual agreement is not a binding agreement relating to distribution and liquidation proceeds, and therefore is not a governing provision, unless a principal purpose of the agreement is to circumvent the one class of stock requirement. See § 1.1361-1(l)(2)(i).

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arrangements between or among an S corporation and its shareholders that may or may not be treated as second classes of stock depending in part on whether a principal purpose of the agreement or arrangement was to circumvent the one class of stock requirement or otherwise alter shareholders’ rights to distribution and liquidation proceeds. See § 1.1361-1(l)(2)(iii)(A) (buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements), § 1.1361-1(l)(4)(ii)(A) (special rules for instruments, obligations, or arrangements treated as equity under general principles of Federal tax law), § 1.1361-1(l)(4)(ii) (B)( 1 ) (short-term unwritten advances that fail the safe harbor described in § 1.13611(l)(4)(ii)(B)( 1 )), and § 1.1361-1(l)(4)(ii) (B)( 2 ) (obligations of the same class that are considered equity under general principles of Federal tax law but fail the safe harbor described in § 1.1361-1(l)(4)(ii) (B)( 2 )). See section 3.01 of this revenue procedure (providing that the IRS will not treat taxpayers who have entered into the agreements or arrangements described in this section 2.03(1)(c) as violating the one class of stock requirement of § 1361(b)(1) (D) so long as there was no principal purpose to use the agreement or arrangement as a means to circumvent the one class of stock requirement).

(2) Disproportionate distributions . A “disproportionate distribution” is any distribution (including an actual distribution, a constructive distribution, or a deemed distribution) of property by a corporation with respect to shares of its stock that differs in timing or amount from the distribution with respect to any other shares of its stock. See § 1.1361‑1(l)(1) and (2). Section 1.1361‑1(l)(2)(i) provides that, “[a]lthough a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.” Despite this regulation providing that “a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights,” taxpayers

and practitioners have indicated concern with the language of § 1.1361‑1(l)(2)(i). The articulated concern is that the word “although” in combination with the subsequent language requiring that certain disproportionate distributions “be given appropriate tax effect” creates uncertainty as to whether an S corporation has created a second class of stock – even though the governing provisions provide identical distribution and liquidation rights with respect to each share. Practitioners suggest that the language in § 1.1361-1(l)(2) (i) could be clarified by removing the word “[a]lthough” and point to inconsistency in PLRs in the treatment of disproportionate distributions. See section 3.02 of this revenue procedure (providing that the IRS will not treat any disproportionate distributions by a corporation as violating the one class of stock requirement of § 1361(b)(1) (D) so long as the corporation’s governing provisions provide for identical distribution and liquidation rights).

(3) Certain inadvertent errors or omis- sions on Form 2553 or Form 8869 . An inadvertent error or omission on Form 2553 or Form 8869 does not invalidate an S election or a QSub election, unless the error or omission is with respect to a shareholder consent, a selection of a permitted year (as defined in § 1378(b) and § 1.1378-1(b)), or an officer’s signature. See generally § 1362(a)(2) (an S election is valid “only if all persons who are shareholders in such corporation on the day on which such election is made consent to such election”), § 1.1378-1 (requiring that the taxable year of an S corporation must be a permitted year, which is defined to include a calendar year or any other taxable year for which the corporation establishes a business purpose to the satisfaction of the Commissioner), and § 1.1361-3(a)(2) (a QSub election form must be signed by a person authorized to sign the S corporation’s return). See section 3.03 of this revenue procedure (providing procedures for a taxpayer to correct, without the receipt of a PLR, an error, an omission, or a missing required consent on a Form 2553 or Form 8869).

(4) Missing administrative acceptance letter for S election or QSub election . Generally, within 90 days after the IRS receives a corporation’s Form 2553, the IRS mails a CP261 Notice as an acknowledgment to

the corporation that the IRS has accepted the corporation’s filing. For QSub elections filed on Form 8869, the IRS mails a CP279 Notice to the filer and a CP279A Notice to the subsidiary, generally within 60 days after the IRS accepts the QSub election. A lack of written acknowledgement that the IRS has accepted the corporation’s S election or its subsidiary’s QSub election (for example, because it was lost or never received) creates uncertainty for some taxpayers about the validity of the election. However, neither subchapter S of the Code nor the Income Tax Regulations thereunder provide that a lack of possession of a CP261 Notice, CP279 Notice, or CP279A Notice affects the validity of an S election or a QSub election, respectively. Rather, such notices are merely administrative acknowledgments of an effective election that can be reproduced upon the taxpayer’s request. See section 3.04 of this revenue procedure (providing procedures to replace a missing CP261 Notice, CP279 Notice, or CP279A Notice).

(5) A Federal income tax return filing inconsistent with an S election or a QSub election . Occasionally, a corporation files a Federal income tax return that is inconsistent with the corporation’s status as an S corporation or a QSub (for example, an S corporation files a Form 1065, U . S. Return of Partnership Income, or Form 1120, U.S. Corporation Income Tax Return, instead of Form 1120-S, U.S. Income Tax Return for an S Corporation ). Although an inconsistent Federal income tax return filing can create several complications for the filer, nothing in the Code or Income Tax Regulations thereunder provides that such a filing affects the validity of a corporation’s S election or QSub election. For example, neither § 1362(d) nor § 1.1361-5(a) lists an inconsistent Federal income tax return filing as an event that gives rise to a termination of an S election or a QSub election. See section 3.05 of this revenue procedure (providing procedures for taxpayers to address, without the receipt of a PLR, a Federal income tax return filing inconsistent with an S election or a QSub election, as appropriate).

(6) Non-identical governing provisions . (a) Overview . Section 1361(b)(1)(D) requires an S corporation to have only one class of stock. Section 1.1361-1(l) provides that a corporation is treated as

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having only one class of stock if all outstanding shares of the corporation’s stock confer identical rights to distribution and liquidation proceeds and if the corporation has not issued any instrument or obligation, or entered into any arrangement, that is treated as a second class of stock. An S corporation in compliance with § 1.13611(l) is commonly referred to as having “identical governing provisions.” The term “non-identical governing provision” means a governing provision, as defined by § 1.1361-1(l)(2)(i), on its own or as part of another governing provision, that for Federal income tax purposes results in the S corporation having more than one class of stock under § 1.1361-1(l)(1) (even if the S corporation never made a non-pro rata distribution or liquidating distribution).

(b) Consequences of non-identical governing provisions . If an entity files an S election when it has more than a single class of stock, the entity does not meet the requirements to be an S corporation and its attempted election is invalid. See § 1361(a)(1). If a valid S corporation later provides for more than a single class of stock, its S election automatically terminates on the day the disqualifying event occurs. See § 1362(d)(2). See section 3.06 of this revenue procedure (providing procedures for correcting, without the receipt of a PLR, the validity or continuation of an S election with regard to one or more non‑identical governing provisions, as defined in section 2.03(6)(a) of this revenue procedure).