Schrödinger’s Corporation
Schrödinger’s cat is a thought experiment, posited by physicist Erwin Schrödinger in reaction to the idea of quantum superposition. Quantum superposition is the concept that something can simultaneously exist in two different states until it is observed, at which point the two different states resolve into one state.
In Schrödinger’s thought experiment, a cat is enclosed in a steel chamber along with a device that, if an atom exists in one state, releases something like iocaine powder (odorless, tasteless, dissolves instantly in liquid, and is one of the deadliest poisons known to man), which instantly kills the cat. If, however, the atom exists in another state, the device does not release the poison and the cat is safe. At some point, the steel chamber will be opened and the observation of the system will render one result: life or death. But until that point, if this system is unobserved (and cats generally ignore everything anyway), quantum superposition requires that Schrödinger’s cat be both alive and dead simultaneously.
Tax advisors often find themselves with Schrödinger’s corporations: corporations that made Subchapter S elections, but have engaged in behavior that terminated the S election. Until the IRS observes those corporations, they exist in this precarious state, both as reporting S corporations and, potentially, as C corporations should the IRS audit and invalidate the corporation’s S election. It’s the retroactivity of the invalidation that makes the situation so interesting from an impact situation – an S corporation that was invalid as of 2010 could have been a C corporation since then and no one knew it until the IRS observed it.
Strained physics analogies aside, we came across a fascinating implication of a Schrödinger’s corporation a few months back. A client was contemplating the purchase of a corporation that had been formed in 2017 and had made a Subchapter S election at the time. Unbeknownst to the shareholders of the corporation, the Subchapter S election had a fatal flaw. The corporation reported consistently under Subchapter S and its shareholders reported their allocable share of corporate income.
Our client now wanted to purchase the assets of this corporation. In diligence, the S election flaw was discovered and the question arose – what is the potential exposure if the IRS audits the corporation and Schrödinger’s corporation is recharacterized as a C corporation?
Generally speaking, this kind of recharacterization is a catastrophe that ranks among the deadliest poisons known to tax advisor – the seller now pays two levels of tax on any gain, potentially at both the federal and state level, resulting in an enormous additional tax liability. But this case was different. It turned out that if the S election was invalid as of the date of formation, the corporation otherwise met the definition of a qualified small business and the stock of the corporation was eligible for the 100% exclusion from tax allowed by Section 1202 of the Code. When we ran the numbers, it turned out that the C corporation recharacterization actually resulted in less tax for the sellers.
In other words, in this case, Schrödinger’s cat had spent years building up an immunity to iocaine powder.
We tell this story not to make Princess Bride jokes (although that’s a nice side benefit), but to point out that every situation is different and minor details can have huge impacts on anticipated tax consequences. Nothing beats having a friendly Acta tax professional by your side who can spot these details and direct you through the Fire Swamp safely.
