PLR 200334017: Inadvertent stock rights defect excused for S election

Plain-English summary

A corporation elected S status while its articles did not ensure identical distribution and liquidation rights for all shares. That defect meant it did not qualify as a small business corporation when the election was made. The corporation later amended its articles, and it represented that it had made equal per-share distributions and that the defect was not motivated by tax avoidance. The IRS found the invalid election inadvertent and, under section 1362(f), treated the corporation as an S corporation from the requested effective date, provided its election was not otherwise terminated.

Ruling snapshot

• Question: Could the corporation retain S treatment despite an inadvertent second-class-of-stock defect?
• Outcome: Approved: S treatment from the requested date, subject to no other termination.
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(f); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200334017
Washington, DC 20224
Release Date: 8/22/2003
Index Number: 1362.04-00 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:1-PLR-103192-03
Date:
May 8 2003

Legend:

X
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State
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D1
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D2
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D3
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D4
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D5
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Dear
:

This responds to a letter dated December 31, 2002, submitted on behalf of X, requesting a ruling that X’s election to be treated as an S corporation was an inadvertent invalid election under § 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted, X was incorporated under the laws State on D1. On D2, X’s articles of incorporation of were amended to provide for voting and non-voting common stock. X elected subchapter S status, effective, D3. At that time, X’s articles of incorporation did not provide that all outstanding shares of X confer identical rights to distribution and liquidation proceeds. X’s legal counsel subsequently discovered that X may have issued more than one class of stock. On D4, X’s articles
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of incorporation were amended to eliminate any second class of stock. On D5, the amended articles of incorporation were filed in the offices of State.

X represents that from D2 through D5 X made equal distributions for each share of stock, and that since D3, X and the shareholder of X filed their returns as if X were a valid S corporation. Further, X represents that the issuance of more than one class of stock was not motivated by tax avoidance.

LAW AND ANALYSIS

Section 1362(a) provides that, except as provided in § 1362(g), a small business corporation may elect, in accordance with the provisions of § 1362, to be an S corporation.

Section 1361(a)(1) provides that the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under § 1362(a) is in effect for such year.

Section 1361(b)(1) defines a "small business corporation" as a domestic corporation that is not an ineligible corporation and that does not (A) have more than 75 shareholders, (B) have as a shareholder a person (other than an estate, other than a trust described in section 1361(c)(2), and other than an organization described in (c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides the general rule that a corporation that has more than one class of stock does not qualify as a small business corporation. Except as provided in paragraph 1.1361-1(l)(4), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.

Section 1.1361-1(l)(2) provides that, in general, the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).

The Committee reports accompanying the Subchapter S Revision Act of 1982 explain
§ 1362(f) as follows:

If the Internal Revenue Service determines that a corporation’s subchapter S election is inadvertently terminated, the Service can waive the effect of the terminating event for any period if the corporation timely corrects the event and if the corporation and the shareholders agree to be treated as if the election had been in effect for such period.
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The committee intends that the Internal Revenue Service be reasonable in granting waivers, so that corporations whose subchapter S eligibility requirements have been inadvertently violated do not suffer the tax consequence of a termination if no tax avoidance would result from the continued subchapter S treatment. In granting a waiver, it is hoped that the taxpayers and the government will work out agreements that protect the revenues without undue hardship to taxpayers . . . . It is expected that the waiver may be made retroactive for all years, or retroactive for the period in which the corporation again became eligible for subchapter S treatment, depending on the facts.

S. Rep. No. 640, 97th Cong., 2d Sess. 12-13 (1982), 1982-2 C.B. 718, 723-24; H.R. Rep. No. 826, 97th Cong., 2d Sess. 12 (1982), 1982-2 C.B. 730, 735.

CONCLUSIONS

Based solely on the facts submitted and the representations made, we conclude that X’s election to be treated as an S corporation was not effective on D3, because X failed to qualify as a small business corporation, and further, that the circumstances resulting in such ineffectiveness were inadvertent. Therefore, pursuant to § 1362(f), X will be treated as an S corporation from D3, and thereafter, provided that X’s subchapter S election is not otherwise terminated under § 1362(d).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

Dianna K. Miosi
Chief, Branch 1
Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes