In an acquisition setting, income tax due diligence of target S corporations generally is focused on the validity of a target’s S corporation status. Corporations found not to be valid S corporations face potentially severe adverse tax implications. Private letter rulings from the IRS historically could provide relief in these situations, if the corporation’s S corporation election was invalid or inadvertently terminated. However, the IRS recently informally indicated that it no longer will issue private letter rulings requested by buyers seeking to verify that the entity they are buying is, and has been, an eligible S corporation. While this position is unofficial, later this year the IRS may issue a revenue procedure or notice formally announcing its new position.
For federal income tax purposes, an S corporation is treated as a pass-through entity, meaning that items of income and loss are allocated and reported to its shareholders and subject to tax on the shareholders’ individual income tax returns. The rules governing S corporations have strict criteria for eligibility. If a corporation’s S election is invalid or has been inadvertently terminated and the corporation is treated as a C corporation, it faces substantial federal and state income tax as well as interest and penalties for tax years from the date the election was terminated. A purchaser of an S corporation that was found to in fact be a C corporation due to an invalid S corporation election or termination of S corporation status would be liable for any historic corporate income tax liabilities. Additionally, if an IRC Section 338(h)(10) or Section 336(e) election is made (to treat the purchase of S corporation stock as a purchase of assets for income tax purposes), the election will be invalid and the buyer will lose the expected step up in tax basis of the target’s assets. As a result, it is extremely important for S corporations to follow the proper procedures when electing S corporation status and ensure that they are continuing to satisfy the S corporation eligibility requirements.
Electing S Corporation Status
A corporation must timely file Form 2553, “Election by a Small Business Corporation,” with the IRS, and all the corporation's shareholders must consent to and sign the election on or before the 15th day of the third month of the election year, or at any time during the preceding tax year.
It is critical to know who is a shareholder for this purpose. For example, if a shareholder resides in a community property state, that shareholder’s spouse may be considered a shareholder and need to consent, even if the spouse does not directly own any shares of the corporation. Corporations in certain states must file a separate state election in addition to the federal S corporation election to be treated as an S corporation.
An S corporation may have a maximum of 100 shareholders. Although this eligibility requirement appears to be fairly objective, S corporations must carefully apply the rules to determine who their shareholders are and whether they should be counted separately or aggregated with other shareholders.
Permissible Types of Shareholders
Each shareholder must be a permissible S corporation shareholder. Permissible S corporation shareholders are U.S. citizens or residents and certain trusts and estates. Depending on the type of eligible trust, the shareholder, for purposes of testing eligibility, could be 1) the trust’s deemed owner, 2) the estate of the deemed owner, 3) the estate of the testator, or 4) the individual for whom the trust was created.
Single Class of Stock
An S corporation is permitted to have only one class of stock outstanding. Under this requirement, while voting rights may diverge, each outstanding share of stock must have identical rights to distribution and liquidation proceeds. All such distributions must be made to shareholders pro rata based on a shareholder’s relative ownership percentage. In making this determination, the corporation’s governing provisions (such as its articles of incorporation and bylaws and any binding agreements relating to distribution or liquidation proceeds) should be reviewed.
Even when the governing provisions provide for identical rights to distribution and liquidation proceeds, a second class of stock might be created where the amount or timing of any actual, constructive, or deemed distribution differs between shareholders. Furthermore, if compensation, management fees, lease payments, interest payments, and other payments made to shareholders or parties related to shareholders exceed an arm’s-length amount, those payments could be characterized, in part, as deemed distributions, raising the possibility that a second class of stock exists. Therefore, transactions and arrangements between shareholders and the S corporation should be analyzed carefully to ensure that they do not result in a second class of stock.
Be Thorough, and Be Prepared
Tax due diligence when considering the acquisition of a target company is especially critical if the target is an S corporation. Acquirers should review the election and maintenance of a target’s S corporation status given the potential adverse material tax consequences if the S corporation status is found to be invalid.