Weekly BNA Insights: The Impact of Proposed Section 385 Regulations on S Corporations

From the Weekly State Tax Report:

The Internal Revenue Service in early April released proposed tax code Section 385 regulations in conjunction with final and temporary regulations on corporate inversions and related transactions. The proposed Section 385 regulations would recharacterize certain debt instruments as stock

The proposed regulations have four sections:

  • Prop. Reg. Section 1.385-1 provides general definitions and operating rules for debt instruments between certain related parties. It also gives the IRS the flexibility to bifurcate certain debt instruments as part debt and part equity under general federal tax principles.

  • Prop. Reg. Section 1.385-2 addresses documentation and information that taxpayers must prepare and maintain within certain time frames to substantiate the treatment of a particular instrument between related parties as debt.

  • Prop. Reg. Section 1.385-3 treats certain debt instruments as stock in specific situations.

  • Prop. Reg. Section 1.385-4 provides special operating rules for applying Prop. Reg. Section 1.385-3 to consolidated return groups.

In the context of corporate inversions, the rules directly challenge earnings-stripping transactions. Outside the context of corporate inversions, the proposed Section 385 regulations potentially have more detrimental effects.

When the rules go final (possibly in September), if S corporation owners and practitioners aren't careful, they may find S corporation status has terminated due to debt being recharacterized into a second class of stock.

PwC's Horacio Sobol and Sam Starr of Bloomberg BNA look at the potential effects proposed tax code Section 385 regulations (REG-135734-15) could have on S corporations in their BNA Insights article, available here (subscription required). Or sign up for a free trial to the Weekly State Tax Report.

Compiled by Melissa Fernley