Treasury’s Section 385 Regs and S Corps

The business community is beginning to recognize that Treasury’s new Section 385 regulations published on April 4th have a much broader reach than anybody thought.  S corporations in particular need to pay attention.

How broad are they?  Here’s how Tax Notes described a meeting of the ABA Section of Taxation here in DC last week:

Practitioners who specialize in the taxation of S corporations said they’re concerned that many S corps may end up gratuitously losing their S corp status if the new related-party debt rules are applied as written without exception.

Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that as he reads the new rules— in particular the bifurcation rule of prop. reg. section 1.385-1(d), which enables the
government to divide a purported debt instrument into part debt and part stock — they could apply to debt issued by an S corp in a way that could automatically invalidate an S corp election.

Released April 4, the proposed section 385 regulations (REG-108060-15) generally treat
related-party debt as equity unless it facilitates new net investment in the borrower’s operations.

Although the regs were released along with a set of new anti-inversion rules, the section 385
regs can apply to transactions that have no connection at all to foreign acquisitions of U.S.
companies. Nichols said May 6 at the S Corporations session of the American Bar Association Section of Taxation meeting in Washington that the rules could turn debt into stock that could potentially violate the S corp single class of stock requirement or the eligible shareholder rule.

The disconnect appears to be that while the Treasury regulations were advertised as targeting corporate inversions, the actual policy would apply to the related party debt of all US companies, not just those moving overseas or seeking to shift income from one tax jurisdiction to another.

The bottom line is the proposed rules appear to give the IRS the ability to re-characterize the related party debt of a large percentage of S corporations.  As S corporation owners know, the downside of having your debt remade into equity is not limited to the loss of an interest deduction.  S corporations are only allowed to have a single class of stock.  If they have more than one class of stock, they revert back to C corporation status.

Existing tax rules provide S corporations a safe harbor to ensure that different forms of debt are not misconstrued as equity and threaten their status.  The proposed 385 regulations appear to override those existing rules.

A final point to make is that the effective date for the proposed regulations is April 4, 2016.  So unless they are pulled entirely, or revised significantly, the proposed regulations already threaten the normal business practices of S corporations across the country.

The business community is gathering its forces to communicate its response to this massive regulatory proposal.  It will be interesting to see if this Treasury Department listens.

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