It looks like the IRS and Treasury have made their revisions to the proposed 385 regulations and are just waiting for sign-off from the White House. According to our friends at Politico:
Tax lawyers just held a big confab in Boston, and, not surprisingly, it was rife with speculation about just what the Treasury Department’s final Section 385 rules might contain. Tax Analysts sifted through some of the unanswered questions and predictions now that Treasury has sent final rules to the White House, including whether the department would only finalize part of the extensive anti-inversion rules it rolled out in April. (If so, one lawyer asked, why wouldn’t the department have sent the White House both proposed and final rules last week?) Also of concern: Will the rules still be retroactive, a particular concern of business? “They’ve got enough fights to pick here,” said David Garlock of EY. “If it’s something that’s clearly expanding the scope of the rules and making it tougher, I can’t imagine that they’re going to risk the validity of the whole package by saying that it’s retroactive to April 4.”
Now that Treasury is done redrafting the rules, the White House (the Office of Information and Regulatory Affairs, really) has up to 90 days to review them and suggest revisions. With the Obama Presidency in its waning days, an extended back and forth here is highly unlikely, and we expect to see something posted in the Federal Register before the end of the year.
The S corporation community needs to pay attention here, because the 385 rules as previously drafted have the potential to blow up S elections. As our comments to Treasury back in July made clear:
As a result, if S corporations were subject to the Proposed Regulations, recharacterization of related party indebtedness as stock would result in the loss of S corporation status in nearly all circumstances. The requirement that qualified subchapter S subsidiaries be 100% owned by the S corporation parent would similarly result in “Q-Sub” disqualification in the vast majority of circumstances. Internal Revenue Code Section 1361(b)(3)(B)(i).
The loss of S corporation and/or “Q-Sub” status, in turn, would result in costs far in excess of the increased taxation resulting from any recharacterization of debt as equity, including the payment of IRS and professional fees necessary to seek restoration of S corporation status, the need to change how the business is financed in order to avoid future disqualifying events, and back taxes and penalties related to the disqualification if the corporation is unable to “cure” the loss of S corporation status with IRS consent.
Will the revisions address the concerns of the S corporation world? The answer is unclear. Tax Notes attended the Boston ABA meeting and had this to report on the S corporation question.
Although a Treasury official said recently that the government is considering changes to the proposed debt-equity regulations to address passthroughs, including S corporations specifically, comments from two IRS officials September 30 left the impression that S corporations might want to prepare for final regs that won’t give them a specific carve-out…
Michael Gould, branch 5 attorney, IRS Office of Associate Chief Counsel (Corporate), acknowledged that when there’s a bifurcation in the case of debt issued between two related S corporations (a brother-sister S corporation scenario), that would cause the S corporation election to be invalidated. “At first blush, yes, it does look that way,” he said, adding that it puts pressure on the question “How far does the second class of stock rule go?”
Those hoping for sympathy from the government left largely empty-handed.
“Ultimately . . . what [section] 385 is saying is: Is it debt? Is it equity? And if it’s equity, the proposed regs say it’s equity for all tax purposes,” Jacobs said. “That’s where we are. We’re saying it’s equity for tax purposes, and what happens from there is all of the other results of all the other provisions.”
So no love for S corporations here, but it is not clear if the lack of understanding was a reflection of the draft sitting over at the White House, or the fact that Treasury officials are necessarily constrained in what they can say about a rule before it’s made public. Only time will tell, but once again the tax world gets a really good example of why Congress needs to legislate carefully. Give the Treasury Department some discretion, and it will use it, even if it takes 47 years.