Haste Makes Waste?

How many of you are suffering from Build Back Better Fatigue? Seriously, it’s a thing.[i]

Sure, the House passed its version of the President’s tax and spending bill on November 19[ii], and the Senate took up the bill after its Thanksgiving recess, with Senate Majority Leader Schumer setting a Christmas deadline for its passage. During this past week, however, certain key Democrats have expressed doubts over Senator Schumer’s timeline. On December 1, the Chair of the House Ways and Means Committee, Richard Neal, said he was skeptical about Congress being able to meet that deadline. The very next day, Senator Manchin intimated that the bill may not be approved this year.[iii]

How about multi-deal fatigue? It’s actually a manifestation of Build Back Better Fatigue.

As discussed in earlier posts[iv], many closely held businesses have been or are being sold in response to the threat of significant tax increases under the above-referenced bill. The sheer number of such purchase and sale transactions[v] has been daunting, but the urgency with which many business owners are seeking to complete them – spurred by the approach of the year end, which they view[vi] as the dividing line on the other side of which await the above-referenced tax increases[vii] – has set a frenetic pace that some owners may come to regret.

For instance, a few business owners seem to have forgotten the negotiating skills that served them so well in building a successful business – they may too readily concede reasonable deal positions rather than push the buyer for a concession, or they may accede to the buyer’s requests rather than resist them or seek some benefit in exchange. Why? To ensure they close before the end of the year.

Just as bad, or perhaps worse, in many cases the business’s “self-due-diligence” that should have preceded the owner’s marketing of the business for sale, including tax due diligence, was either overlooked or performed shoddily; for example, confirming that the business’s tax elections are in order and remain in effect.[viii]

S Corporation Elections

Imagine, for example, a closely held business organized as a corporation that elected many years ago to be treated as an S corporation for tax purposes.[ix] Imagine also that several years ago one of the corporation’s shareholders made a gift transfer[x] of some of their shares of the S corporation’s non-voting[xi] stock to a trust for the benefit of the shareholder’s child.

Imagine the trust was properly drafted as a qualified subchapter S trust[xii] (or “QSST”), that the trustee observed the terms of the trust[xiii], and the current income beneficiary reported the trust’s pro rata share of the S corporation’s items of income, deduction, gain, loss, and credit.[xiv] Finally, imagine the owners – who have no shareholders’ agreement – have just signed a letter of intent for the sale of the corporation’s business.

Sounds good, right? There’s a catch, though.

When asked to produce a record of the beneficiary’s timely election to treat the trust as a QSST, none can be found – indeed, according to the beneficiary and the trustee, none was ever made because no one had ever informed them that a trust cannot be treated as a QSST unless the current income beneficiary files an election with the IRS identifying the S corporation of which the trust is a shareholder and identifying the trust as a permitted shareholder of such S corporation.[xv] Moreover, the election must have been made within the 16-day-and-2-month period beginning on the day the stock was transferred to the trust.[xvi]

Don’t Cry Over a Missed Election?

Maybe you should.

As a result of the beneficiary’s not having made a timely QSST election, the trust cannot hold shares of a corporation without causing the corporation to lose its S corporation status – in other words, the corporation that had been treated as a pass-through entity for tax purposes, the income and gains of which were not taxed to the corporation but, rather, to its shareholders, suddenly finds itself as a taxable C corporation, the income and gains of which are subject to so-called “double taxation”: once to the corporation and then to its shareholders when the corporation distributes its after-tax profits.

Sale of Assets

Imagine the target corporation had sold its assets while it still qualified as a small business corporation (i.e., before the transfer of shares to the non-electing trust). Assuming the corporation is not subject to the built-in gains tax[xvii], and assuming all of the gain from the sale of the assets is treated as long-term capital gain, each shareholder will be taxed at the federal rate of 20 percent.[xviii]

Now assume the asset sale occurs after the S election has been lost. The C corporation is taxed on its gain at the federal corporate rate of 21 percent. The after-tax proceeds are then distributed to the shareholders in liquidation of the corporation; the shareholders are taxed at a federal rate of 23.8 percent[xix]. This makes for an effective federal tax rate of 39.8 percent.

Sale of Stock

Although the taxation of the gain recognized by its shareholders on the sale of all the target corporation’s issued and outstanding shares of stock will not, generally speaking, be affected by the corporation’s tax status as an S corporation,[xx] the corporation’s failure to qualify as an S corporation at the time of the sale may have serious consequences for an unsuspecting buyer and, therefore, for the selling shareholders who represented to the buyer that the corporation’s “S” election remained in effect.

Specifically, the buyer may have relied upon the target’s status as an S corporation to make a joint election under IRC Sec. 338(h)(10) with the selling shareholders[xxi] to treat the stock deal[xxii] as a deemed sale of assets by the target S corporation followed by its deemed liquidation.[xxiii] As a result of the election, the buyer would enjoy the benefit of a basis step-up for the “acquired” assets; it may thereby recover its purchase price for the target by claiming depreciation, amortization, and expense deductions in respect of these assets.

F Reorganization

What’s a buyer to do if the seller is unable to produce satisfactory evidence of its continuing S corporation status? The buyer may suggest that the target corporation engage in an F reorganization.[xxiv] In brief, the target shareholders would organize a new S corporation to which they would contribute all their target corporation shares; a QSub election[xxv] would be made for the target[xxvi]; the target would then be merged (or converted, if state law provides for a conversion[xxvii]) into an LLC that is wholly owned by the new corporation and disregarded for tax purposes.[xxviii]

The end result of such a restructuring is that the business of the “original” S corporation is moved into a wholly owned subsidiary that is disregarded for tax purposes[xxix], the membership interests of which may be sold by the S corporation to the buyer. From the buyer’s perspective, its acquisition of all the membership interests in the target is treated as a purchase of assets, thus giving the buyer the desired basis step-up, while leaving the target’s income tax history[xxx] with the target corporation (more appropriately, its “successor” from a state law perspective).

Restoring the “S”

Although the F reorganization of a target corporation may address the buyer’s concern over the validity of the target’s “S” election and the buyer’s ability to achieve a basis step-up for the target’s assets while acquiring the target’s equity, it does nothing to address the increased tax exposure for the target and its shareholders resulting from the target’s status as a “C” corporation.

The only way to address the foregoing is by restoring the “S” election.


Congress recognizes that folks sometimes make mistakes.[xxxi] That’s why the Code authorizes the IRS to continue treating a corporation as an S corporation (i.e., to waive the termination of its election) if the corporation’s “S” election was terminated inadvertently, steps were taken after discovery[xxxii] of the terminating event[xxxiii] to bring the corporation back into compliance, and the corporation and its shareholders agree to report as though the corporation continued to be treated as an S corporation.[xxxiv]

If a corporation believes that the termination of its “S” election was inadvertent, it may ask request a private letter ruling from the IRS to that effect. This request would set forth a detailed explanation pertaining to the event causing the termination, when and how the event was discovered, and the steps taken to remedy the termination.[xxxv]

Letter Ruling Request

The IRS has promulgated regulations[xxxvi] which provide the standards the IRS will use to determine whether to grant a taxpayer an extension of time to make a “regulatory election;”[xxxvii] this includes an election the due date of which is prescribed by a regulation (which includes a QSST election).[xxxviii] If the IRS determines these standards are satisfied – together with those prescribed under the S corporation regulations (see immediately below) – it may exercise its discretion to grant a reasonable extension of time to make the election.

The IRS is authorized to grant relief if, for example, a corporation’s “S” election terminated due to the failure of the current beneficiary to make a timely QSST election.[xxxix] The corporation is eligible for such relief if (1) the IRS determines that the event resulting in the termination (the failed election, in this case) were inadvertent, (2) no later than a reasonable period of time after discovery of the event, steps were taken so that the S corporation is a “small business corporation” (in this case, the taxpayer is seeking permission from the IRS to make a late election), and (3) the corporation, and each person who was a shareholder of the corporation at any time during a period to be designated by the IRS[xl], agree to make such adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the IRS with respect to such period.[xli]

If a corporation is eligible for relief under this provision, then, notwithstanding the event resulting in the termination, the IRS will grant relief for both the late QSST election and the inadvertent termination of the S corporation election resulting therefrom.

According to IRS Regulations[xlii], the corporation has the burden of establishing that, under the relevant facts and circumstances, the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation (an election by the current income beneficiary of the trust?) and was not part of a plan to terminate the election, or the fact that the event took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard against such an event, tends to establish that the termination was inadvertent.

In addition to meeting the criteria under the “S” regulations described above, the taxpayer must provide sufficient evidence to establish to the satisfaction of the IRS that the taxpayer acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the government.

Reasonably and in Good Faith

A taxpayer is deemed to have acted reasonably and in good faith if the taxpayer:[xliii] (i) requested relief before the failure to make the election was discovered by the IRS; (ii) failed to make the election because of intervening events beyond the taxpayer’s control; (iii) failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer’s experience and the complexity of the issue), the taxpayer was unaware of the necessity for the election; (iv) reasonably relied on the written advice of the IRS; or (v) reasonably relied on a qualified tax professional, and the tax professional failed to make, or advise the taxpayer to make, the election.[xliv]

A taxpayer is deemed not to have acted reasonably and in good faith if the taxpayer: (i) seeks to alter a return position for which an accuracy-related penalty[xlv] has been or could be imposed at the time the taxpayer requests relief and the new position requires or permits a regulatory election for which relief is requested; (ii) was informed in all material respects of the required election and related tax consequences, but chose not to file the election; or (iii) uses hindsight in requesting relief. If specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer, the IRS will not ordinarily grant relief.[xlvi]

Prejudice to the Government

The IRS will grant a reasonable extension of time to make a regulatory election only when the interests of the government will not be prejudiced by the granting of relief. The IRS will use the following standards to determine when the interests of the government are prejudiced: (i) The interests of the government are prejudiced if granting relief would result in a taxpayer having a lower tax liability in the aggregate for all taxable years affected by the election than the taxpayer would have had if the election had been timely made (taking into account the time value of money); (ii) The interests of the government are ordinarily prejudiced if the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made are closed by the period of limitations on assessment[xlvii] before the taxpayer’s receipt of a ruling granting relief under this section.

Under the facts described above, a late QSST election should not be viewed as prejudicing the government, notwithstanding the limitations period for assessing additional tax has closed for several taxable years, because the current income beneficiary has been including in its gross income, and paying tax on, the trust’s pro rata share of the corporation’s items of income and gain.[xlviii]

Rev. Proc. 2013-30 – An Easier Way?

The foregoing letter ruling process can be quite involved and quite expensive, thanks in part to the user fee that the IRS charges for letter rulings.[xlix]

In order to facilitate the granting of relief for late elections, the IRS issued Rev. Proc. 2013-30,[l] which provides procedures for certain failed elections with respect to S corporations that are in lieu of the letter ruling process ordinarily used to obtain relief for such a late election.[li]

Significantly, this procedure applies to requests that are made within 3 years and 75 days after the date on which the election is intended to be effective.[lii]

In the case of a failed QSST election, relief may be requested by properly completing the required election and attaching the supporting documents. In addition, a “Reasonable Cause/Inadvertence Statement” must be submitted that describes the failure to timely file the QSST election was inadvertent, and its diligent actions to correct the mistake upon its discovery.

The current income beneficiary of a QSST must sign and file the appropriate election, which must include the following statements: (1) A statement from the current income beneficiary that identifies the beneficiary, the trust and the corporation, and the intended effective date; (2) a statement from the trustee that the trust satisfies the QSST requirements and that the income distribution requirements have been and will continue to be met; and (3) Statements from all shareholders during the period between the date the S corporation election was terminated and the date the completed election is filed that they have reported their income on all affected returns consistent with the S corporation election for the year the election should have been made and for all subsequent years.

Upon receipt of a completed request for relief under this revenue procedure, the IRS will determine whether the requirements for granting additional time to file the election have been satisfied.

Twenty-Three Days to Go

The December 31 “deadline” for whatever “Beat the Build Back Better Effective Date Transactions” remain to be completed is almost upon us.

In most cases, the sellers of S corporations are already aware of the tax consequences arising from the disposition of their shares of stock or of their corporation’s assets.

However, for those sellers with corporations that may have (or are likely to have) lost their “S” status because of a missed election with respect to a shareholder trust, the approach of the year-end may be especially stressful. Hopefully, they’ve requested relief from the IRS using one of the alternatives described above[liii], they will agree to whatever the buyer reasonably requests in light of the circumstances, they will close their transaction, and they’ll await the IRS’s determination.

Then again, their deal may have been deferred into 2022, pending the receipt of a favorable ruling by the IRS (meaning they will not beat the above deadline).

Still others may have lost their deal because the buyer understandably got cold feet.

Those S corporations and shareholders who did not join this year’s sale frenzy should take stock of the foregoing. That shareholders’ agreement you’ve neglected for years? Yeah, that one. Make sure it obligates the shareholders to disclose their intentions to, and to share transfer documents with, the corporation before any transfer is undertaken for gift or estate tax planning purposes. Require that copies of all necessary elections be provided promptly to the corporation. Ensure that the shareholders are obligated to consent to any tax adjustments the IRS may require as a condition to its waiving an inadvertent termination of the corporation’s “S” election. Finally, get it signed.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] I sure hope I used that phrase correctly.

[ii] https://www.cnn.com/2021/11/19/politics/house-vote-build-back-better/index.html.

[iii] https://www.cnn.com/2021/12/02/politics/joe-manchin-biden-build-back-better/index.html.

What did Pres. Lincoln say about a house divided? Speaking of which, we’re approaching the anniversary of the admission of Texas as a State. Did you know that one year earlier, Massachusetts affirmed its right to secede if Texas were admitted?

That said, it appears the Dems have found a way to raise the debt ceiling.

[iv] See, e.g., https://www.rivkinradler.com/publications/tax-hikes-effective-dates-and-selling-a-business/ ; https://www.taxslaw.com/2021/10/gifts-sales-and-effective-dates-the-race-against-the-clock-the-taxpayer-cannot-see/

[v] Most include a rollover of some equity which may qualify for gain deferral under IRC Sec. 721 or Sec. 351 (primarily the former).

[vi] Whether rightly or wrongly remains to be seen, especially given the divisions within the majority Party’s own ranks.

[vii] Think land of the living, the River Styx, and the Underworld.

[viii] For example, a corporation’s election to be treated as an S corporation.

[ix] IRC Sec. 1361 and Sec. 1362. In order to qualify as an S corporation, the corporation must be a small business corporation for which an election has been made. A “small business corporation” means a domestic corporation which is not an “ineligible corporation,” and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, certain trusts, or certain tax-exempt organizations) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than 1 class of stock.

[x] Let’s assume the gift was made late in 2012, just before another December 31 deadline that (thankfully) turned out to be a false alarm, thanks to a retroactive effective date.

[xi] See IRC Sec. 1361(c)(4): an S corporation shall not be treated as having more than 1 class of stock solely because there are differences in voting rights among the shares of common stock.

[xii] IRC Sec. 1362(d); Reg. Sec. 1.1361-1(j).

[xiii] For example, they made annual distributions of the trust’s income to the trust’s only current income beneficiary.

[xiv] Under IRC Sec. 1361(d)(1)(B), the income beneficiary of a QSST is treated (under IRC Sec. 678) as the “owner” of that portion of the trust that consists of S corporation stock; the beneficiary is treated as the shareholder for purposes of the pass-through, basis and distribution rules applicable to S corporation shareholders. But see Treas. Reg. 1.1361-1(j)(7). But see Treas. Reg. 1.1361-1(j)(8) which provides that the beneficiary will not be treated as the owner of the stock for purposes of determining the income tax consequences from the disposition of the stock by the trust.

[xv] Treas. Reg. Sec. 1.1361-1(j)(6). IRC Sec. 1361(c)(2)(A).

[xvi] Treas. Reg. Sec. 1.1361-1(j)(6)(iii).

[xvii] IRC Sec. 1374 imposes a corporate-level tax on certain S corporations.

[xviii] Let’s assume that the sale occurs before the enactment of the Build Back Better bill, and that every shareholder is a material participant in the business. Thus, the 3.8 percent surtax on net investment income will not apply. IRC Sec. 1411.

[xix] 20 percent capital gains rate on the liquidating distribution plus 3.8 percent surtax on net investment income.

[xx] There is an exception under current law when the selling shareholder of S corporation stock was a material participant in the corporation’s business – the gain recognized by such a selling shareholder is not subject to the 3.8 percent surtax. IRC Sec. 1411(c)(4).

[xxi] Or if the selling shareholders had agreed with the buyer that they would make an election under IRC Sec. 336(e).

[xxii] There are many reasons a buyer may want to acquire a target’s equity rather than its assets; for example, there may be difficult-to-transfer assets, or it may be important to the buyer that the target’s EIN be preserved.

[xxiii] Treas. Reg. Sec. 1.338(h)(10)-1.

Of course, the buyer may be just as surprised at having acquired a taxable corporation that had not paid its income tax for several years. In that case, the buyer will exercise its rights under the sale agreement to compel the seller to indemnify the buyer for any pre-sale tax liabilities of the corporation. That said, the filing of the S corporation tax return (instead of a C corporation return) for a particular year should usually suffice to start the running of the limitations period on the assessment of corporate level tax. IRC Sec. 6501.

[xxiv] IRC Sec. 368(a)(1)(F). https://www.taxslaw.com/2021/11/selling-to-private-equity-maybe-you-should-f-reorg-first/. Did you think I was going to say something else? I confess, I started to.

[xxv] IRC Sec. 1361(b)(3).

[xxvi] Thereby preventing the target from becoming a C corporation.

[xxvii] New York does not, Delaware does. Surprise.

[xxviii] See Rev. Rul. 2008-18 which describes the consequences of an S corporation’s reorganization under IRC Sec. 368(a)(1)(F) using the above structure.

[xxix] Treas. Reg. Sec. 301.7701-3.

[xxx] IRC Sec. 381. State and local sales tax history, for example, is another matter.

[xxxi] They know from personal experience.

[xxxii] It should go without saying, the sooner the better.

[xxxiii] The event that caused the termination (for example, failure to make an election) may have occurred years earlier.

[xxxiv] IRC Sec. 1362(f); Treas. Reg. Sec. 1.1362-4.

It should be noted that if a corporation’s “S” election is terminated, and the corporation does not qualify for relief from such termination, it cannot re-elect “S” status for five taxable years after the year of the termination. IRC Sec. 1362(g). That said, IRS may consent to an earlier election if warranted.

[xxxv] Treas. Reg. Sec. 1.1362-4(c).

[xxxvi] Treas. Reg. Sec. 301.9100-3.

A request under Treas. Reg. Sec. 301.9100 must be in the general form of, and meet the general requirements for, a letter ruling request. These requirements are given in section 7 of Rev. Proc. 2021-1. The request must include an affidavit and declaration from the taxpayer and other parties having knowledge or information about the events that led to the failure to make a valid regulatory election and to the discovery of the failure. See Sec. 301.9100-3(e)(2) and (e)(3). In addition, a Sec. 301.9100 request must include the information required by Sec. 301.9100-3(e)(4).

[xxxvii] Please note that the granting of an extension of time is not a determination that the taxpayer is otherwise eligible.

[xxxviii]  See Treas. Reg. Sec. 601.601(d)(2).

[xxxix] IRC Sec. 1362(f).

[xl] Treas. Reg. Sec. 1.1362-4(f). The status of the corporation after the terminating event and before the determination of inadvertence is determined by the IRS. Commissioner. Relief from an inadvertent termination may be granted retroactively for all years for which the terminating event is effective, in which case the corporation is treated as if its election was valid or had not terminated. Alternatively, relief may be granted only for the period in which the corporation became eligible for subchapter S treatment, in which case the corporation is treated as a C corporation during the period for which the corporation was not eligible for “S” status. (Think built-in gains tax exposure?)

[xli] Treas. Reg. Sec. 1.1362-4(e).

[xlii] Treas. Reg. Sec. 1.1362-4 sets forth guidance regarding inadvertent termination relief.

[xliii] Treas. Reg. Sec. 301.9100-3(b)(l).

[xliv] A taxpayer will not be considered to have reasonably relied on a qualified tax professional if the taxpayer knew or should have known that the professional was not (i) competent to render advice on the regulatory election, or (ii) aware of all relevant facts. Treas. Reg. Sec. 301.9100-3(b)(2).

[xlv] IRC Sec. 6662.

[xlvi] In such a case, the IRS will grant relief only when the taxpayer provides strong proof that the taxpayer’s decision to seek relief did not involve hindsight.

[xlvii] IRC Sec. 6501(a).

[xlviii] IRC Sec. 1366.

[xlix] See Appendix A to Rev. Proc. 2021-1. The fee is $12,500

[l] https://www.irs.gov/irb/2013-36_IRB#RP-2013-30.

[li] User fees do not apply to corrective actions under this revenue procedure.

[lii] Sec. 4.02(2) of the revenue procedure.

[liii] Expedited handling is doubtful under these circumstances.