Posted by Aurelia E Weems CPA

Final Regulations Eligible Terminated S Corporation Rules

Final Regulations Eligible Terminated S Corporation Rules

The IRS has issued final regulations on qualifying terminated S corporations and cash distributions of such corporations after the PTTP (post-termination transition period). The final regulations implement the provisions added by the TCJA Act and adopt, with some modifications, the draft regulations published in 2019.


Background: 

The TCJA added two eligible terminated S Corp provisions to the code in sections 481 (d) and 1371 (f) of the IRC. IRC Section 481 (d) (2) defines an eligible terminated S Corp as a C Corps: 

  1. Company that was an S company on December 21, 2017

  2. That rescinded its S election within the two years beginning on December 22, 2017, and 

  3. On the date of revocation of its S elections and on December 22, 2017, Whose shares were held by the same shareholders in identical proportions.

Under IEC Section 481 (d) (1), an eligible terminated S Corp may consider any changes to IEC Section 481 that can be attributed to the revocation of an S election during the inclusion period of Section 481 (d) of the IEC, i.e., the six years tax period, beginning with the year of the change.

The IRC section 1371(f) extends the period during which the shareholders of an eligible terminated S Corp can benefit from its Accumulated Adjustment Account (AAA) generated during the company's previous status as an S Corps. The Accumulated Adjustment Account generally deals with corporate stock profits. It represents the amount it can distribute to its shareholders (usually tax-free) before deferred profits and corporate profits (generally taxable as dividends). Under IRC Section 1371 (f), if an eligible terminated S Corp distributes money after PTTP, the Accumulated Adjustment Account is allocated to the distribution. The distribution is taxed to AE&P in the same proportion as Accumulated Adjustment Account leads to AE&P.

In November 2019, the IRS issued the draft regulation to the eligible terminated S Corp under IRC Sections 481 and 1371.


THE FINAL REGULATIONS: 

The final regulations adopt the proposed rules for 2019, with some modifications in response to the comments received, including changes to an S election's revocation date to qualify as an eligible terminated S Corp under section 481 (d) of the IEC (explained below). The final settlement is primarily under the proposed rules on mechanisms in section 1371 (f) of the IRC, including eligible shareholders to receive eligible distributions, the implementation of the eligible terminated S Corp distribution, and the nature and effect of the distributions during the eligible terminated S Corp.


Qualification As An Eligible Terminated S Corp: 

According to Section 1362 (d) (1) of the IEC, the revocation of S elections during the first two and a half months of a financial year is generally effective from the beginning of the financial year; if it is made after the first two and a half months of the fiscal year, the revocation takes effect at the beginning of the following fiscal year. However, a revocation may specify a potential effective date, in which case the revocation will take effect on the date indicated.

As mentioned earlier, a company must revoke its S election within two years from December 22, 2017, to become an eligible terminated S Corp. The final regulations set the following rules for these two years:

  • Like the proposed regulation, the final regulation considers that the revocation obligation is fulfilled if the revocation of an S election is validly carried out within two years from December 22, 2017, even on the expiration date of revocation of the two periods.

  • To comply with the revocation obligation and the shareholder identity requirement for revocation retroactive to the start of the financial year in which the revocation took place, a company can demonstrate compliance with these requirements on the date of revocation or its retroactive date.

  • Since the last day of the two years from December 22, 2017, being Saturday (December 21, 2019), the final regulation also specifies that IRC Section 7503 will apply to process a revocation made on December 23, December 2019, as made over the two years.

Inapplicability of Section 481 (d) of IRC to eligible subsidiaries of subchapter S (QSubs):

For an ETSC, Section 481 (d) of the IRC considers the adjustments required by Section 481 (a) of the IRC that can be attributed to the dissolution of the S corp. It is counted proportionally for a six-period fiscal year, starting with the year or change. Section 481 (d) of the IRC was enacted primarily to deal with the cash-basis S corporation switch to an accrual method after the termination of its S option.

Suppose company S has a QSub on the effective revocation date of its S elections. In that case, the current choice of QSub for the subsidiary ceases, and the company is considered to contribute the assets of the subsidiary (subject to the liabilities) to a new one C Corporation on an IRC Section 351. Suppose the former QSub was a cash-basis taxpayer. In that case, the assets considered to be contributions are likely to include loans for which the subsidiary would have no basis, which will result in recognition of income when loans will be debited.

 

Applicability of the PTTP and ETSC period for non-profit and deferred profit (AE&P) companies:

IRC Sections 1371 (e) and (f) refer to AAA distributions from a former S corporation after its S elections. For technical reasons, an S corporation that does not have AE&P is not required to maintain an AAA. As a result, commentators have asked the IRS and the treasury to confirm that the PTTP and ETSC distribution rules apply to older S corporations without AE&P. The IRS and Treasury did not address this request in the final regulations. Still, they confirmed in the preamble that the PTTP and ETSC rules apply to a former S corporation without AE&P, noting that an example in the final settlement referred to a former S company without AE&P.


Application of PTTP and ETSC distribution rules to new shareholders: 

Before Treas. Reg. As amended by Section 1.1377-2 (b) of these final regulations, the special treatment provided for in Section 1371 (e) (1) of the IRC (on cash distributions during a company's PTTP) is limited to shareholders who were shareholders of the company at the time of the closure or revocation of the S elections (there are no rules for newcomers). The final regulation amends the treasury. Reg. Section 1.1377-2 (b) to remove the newcomer rule. Therefore, after the company's elections, people who become shareholders can benefit from a special cash distribution treatment during a company's PTTP. Under the proposed regulation, the final regulation also removes the new entry ban rule within the meaning of the ETSC distribution provisions.


Rules concerning the sharing of ETSC distributions between AAA and AE&P:

The final regulation rules on the allocation of ETSC distributions between AAA and AE&P are substantially similar to those imposed by the proposed legislation.


Effective Dates:

The final rules generally apply to fiscal years from the date of publication in the Federal Register. However, a company may choose to apply certain rules to fiscal years on or after that date, including the removal of the non-novice rule for PTTP distribution for periods for which valuation restriction status remains open, provided that all shareholders submit consistent reports and that the company continues to apply these rules in the coming years.


THE EFFECTS:

The final regulation generally adopts what the preamble to the draft regulation calls an immediate approach for sourcing distributions. According to this approach, the proportion of cash distributions during the ETSC period is usually based on a fixed proportion, which is calculated as AAA from the day the company is first treated as a C company after the withdrawal, divided by the amount of AAA and AE&P as of that day. This index remains constant until:

  1. the company runs out of AAA, in which case the ETSC period ends, or 

  2. The company runs out of AE&P, in which case the ratio becomes 1. Even the final regulations adopt the preamble to the proposed regulations described as Section 1371 (f) IRC Priority Rule. Hence, the special ETSC rules apply earlier than the normal C Corporation distribution rules (which, by example, would generate distributions for E&P before the current rule).

The elimination of the newcomer rule for PTTP distribution rules is a welcome development. As mentioned above, a business can choose to apply cash. Reg. Section 1.1377-2 (b) without the non-new rule for fiscal years in which the contribution limitation period remains open. A company that distributed money during a PTTP to new shareholders for whom the fiscal year remains open should consider whether it and its shareholders should have changed returns to benefit from removing the new rule. In addition to changing your tax returns, your tax returns can also change.

The final ETSC Distribution Rules regulations are taxpayer-friendly with the passage of Section 1371 (f) IRC Instant Approach and Priority Rule. The ETSC should consider using these rules to make tax-exempt or partially tax-exempt distributions to its shareholders.


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