SC&H Group Blog: "Expertise Beyond the Numbers"

Three Recent Taxpayer-Friendly S Corporation Rulings [Blog Post]

The following blog post from Sarah Ryan of SC&H Group’s Tax Services team provides a summary of three recent taxpayer-friendly rulings concerning the one class of stock requirement for S Corporation elections.

Earlier this year, the IRS issued three private letter rulings benefiting S Corporations. In each of these situations where compensation amounts and distributions were called into question, the IRS determined that the S Corporations did not create a second class of stock.

Furthermore, the IRS ruled that excessive compensation, disproportionate distributions, and/or corrective distributions will not create a second class of stock, and therefore, will not terminate an S election as long as:

  • The S Corporation’s governing provisions provide that each share of stock has identical rights to distribution and liquidation proceeds; and
  • The S Corporation’s principal purpose is not to circumvent the one class of stock requirement.

Below is a summary of each ruling:

  • Ruling #1 Regarding Excessive Compensation: In this ruling released February 12, 2016, an S Corporation paid excessive compensation to an at-will shareholder-employee who did not have a compensation agreement. According to the S Corporation, each share of its stock had identical rights to distributions and liquidation proceeds. Moreover, circumventing the one class of stock requirement was not the principal purpose of the excessive compensation. The IRS concluded that no second class of stock was created and therefore, the S election was not terminated.
    • Note – An employee agreement is not a binding agreement relating to distribution or liquidation proceeds, so even if the employee had one, it would not have changed the IRS conclusion.
  • Ruling #2 Regarding Disproportionate Distributions: In this ruling released February 19, 2016, an S Corporation made disproportionate distributions to shareholders to cover their expected federal tax liability based on their pro-rata share of pass-through income from the entity. According to the S Corporation, each share of its stock had identical rights to distributions and liquidation proceeds, a provision did not exist that varied such rights, and shareholders repaid the disproportionate distributions in full. In addition, the state laws in which the S Corporation was incorporated did not allow disproportionate distributions. The IRS concluded that no second class of stock was created and therefore, the S election was not terminated.
    • Note – Even if the shareholders had not repaid the disproportion distributions, it would not have changed the IRS conclusion.
  • Ruling #3 Regarding Corrective Distributions: In this ruling released February 19, 2016, an S Corporation filed tax returns in various states and paid state composite or withholding income taxes as required for its nonresident shareholders in each state. The S Corporation paid out annual distributions on a ratable per share basis. Each shareholder’s distributions were supposed to be reduced by the amount of state composite and withholding taxes paid by the S Corp on their behalf.However, the S Corporation discovered that it inadvertently reduced all shareholders’ distributions ratably by the total amount of state composite and withholding taxes paid for nonresident shareholders, resulting in disproportionate distributions.According to the S Corporation, each share of its stock had identical rights to distributions and liquidation proceeds, and no provision existed to vary such rights.  The S Corporation made corrective distributions to true-up each shareholder’s aggregate distributions in proportion to their ownership percentages for all tax years. It also implemented policies to ensure state composite and withholding taxes paid on behalf of nonresident shareholders would be equalized annually with reciprocal cash distributions to the other shareholders.  The IRS concluded that no second class of stock was created and therefore, the S election was not terminated.
    • Note – Even if the S Corporation did not make corrective distributions and just let the disproportionate distributions remain, it would not have changed the IRS conclusion.

While these elections were not terminated, private letter rulings cannot be cited directly as precedent and are expensive to obtain. Therefore, companies should still maintain proportionate distributions in an S Corporation environment at all times.

If you have any questions about how to qualify for S Corporation status, or if you would like to discuss any issues regarding your status, please contact SC&H Group’s Tax Services team here.

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