PLR 200546027: S corporation status preserved after possible second stock class

Plain-English summary

An S corporation feared that unequal shareholder distributions and its shareholder agreements might have created a prohibited second class of stock. It represented that it had not intended that result and described corrections, including treating excess distributions as shareholder loans and changing the agreement to require proportionate distributions and fair market value share purchases. The IRS did not decide that the S election had actually terminated. It ruled that any termination from the possible second stock class was inadvertent and that the corrective actions did not create a second class. The corporation would continue to be treated as an S corporation from the redacted effective date, provided its election was not otherwise terminated.

Ruling snapshot

• Question: Would a possible second class of stock end the corporation's S status despite corrective actions?
• Outcome: Approved for inadvertent termination relief if a termination occurred, subject to other S election requirements.
• 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
Washington, DC 20224
Number: 200546027
Third Party Communication: None
Release Date: 11/18/2005
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B01
PLR-127954-05
Date:
July 27, 2005

Legend:

X = ----------------------------------------
------------------------------------------------------------

Y = ------------------------------------------

State = ---------------

Date 1 = -----------------

Date 2 = ----------------------

Date 3 = -------------------

Year 1 = -------

Year 2 = -------

Dear ------------------:

This letter is in response to your request, dated May 20, 2005, on behalf of X, seeking inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

Facts

Based on the materials submitted and representations within, we understand the relevant facts to be as follows. X was incorporated on Date 1 in accordance with the laws of State under the name of Y. X made an election to be treated as an S corporation effective Date 2. X determined that due to its distributions to its

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shareholders and the terms of the shareholder agreements entered into, X may have inadvertently created a second class of stock in violation of the one class of stock requirement in section 1361(b)(1)(D).

X represents that it did not intend to create a second class of stock. As soon as X realized the problem, X under took steps to correct the problem. X represents that it either will, or already has under taken the following corrective actions to alleviate any possible problems: (1) recharacterization of distributions in excess of shareholder’s rightful amount as loans between X’s shareholders that are to be repaid, with interest, by Date 3; and (2) amending the current shareholder agreement. The amended shareholder agreement will mandate that the purchase price for the shares of X be equal to fair market value and will require that all distributions to shareholders be in amounts proportionate to stock ownership in X. X and its shareholders agree to make any adjustments, consistent with the treatment of X as an S corporation, as might be required by the Secretary.

Law and Analysis

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 section 1362(a) is in effect for the year.

Section 1361(b)(1)(D) provides that, for purposes of subchapter S, the term "small business corporation" means a domestic corporation that is not an ineligible corporation and that does not, among other things, have more than one class of stock.

Section 1.1361-1(I)(1) of the Income Tax Regulations provides that a corporation is generally 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.

Section 1.1361-1(I)(2)(i) provides that 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"). A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a principal purpose of the agreement is to circumvent the one class of stock requirement. Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

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Section 1.1361-1(I)(2)(iii)(A) provides that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation's outstanding shares of stock confer identical rights unless a principal purpose of the agreement is to circumvent the one class of stock requirement and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock. Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and thus, are disregarded in determining whether the outstanding shares of stock confer identical rights.

Section 1.1361-1(I)(2)(iii)(B) provides that bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation's shares of stock confer identical rights.

Section 1.1361-1(l)(2)(iii)(C) provides that a determination of book value will be respected if the book value is determined in accordance with generally accepted accounting principles (including permitted adjustments) or if the book value is used for a substantial nontax purpose.

Section 1362(d)(2)(A) provides that an election under section 1362(a) will be terminated whenever (at any time on or after the 1st day of the 1st taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation. Section 1362(d)(2)(B) provides that the termination shall be effective on and after the date of cessation.

Section 1362(f) provides that if (1) an election under section 1362(a) by any corporation (A) was not effective for the taxable year for which made (determined without regard to section 1362(b)(2)) by reason of a failure to meet the requirements of section 1361(b) or to obtain shareholder consents, or (B) was terminated under section 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in such ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness or termination, steps were taken (A) so that the corporation is a small business corporation, or (B) to acquire the required shareholder consents, and (4) the corporation, and each person who was a shareholder in the corporation at any time during the period specified pursuant to section 1362(f), agrees to make such adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to such period, then, notwithstanding the circumstances resulting in such ineffectiveness or termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.

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Conclusion

Based on the information submitted and the representations made, we conclude that X’s S corporation election may have terminated because X may have had more than one class of stock. However, we conclude that, if X’s S election was terminated, such a termination was inadvertent within the meaning of § 1362(f) of the Code. Further, we conclude that the corrective action taken by X and its shareholders does not create a second class of stock under section 1361. Consequently, we rule that X will be treated as continuing to be an S corporation from Date 2, and thereafter, provided that X’s S election otherwise is not terminated under § 1362(d).

Except as specifically ruled upon above, no opinion is expressed as to the federal income tax consequences of the facts described above under any other provision of the code. In particular, no opinion is expresses or implied as to whether X otherwise qualifies as a subchapter S corporation under § 1361.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and are accompanied by a perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of this request, it is subject to verification on examination.

This ruling is directed only to the taxpayer who requested 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 ruling will be sent to the taxpayer representatives.

Sincerely,

/s/ David R. Haglund

David R. Haglund
Senior Technician Reviewer, Branch 1
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures (2)
Copy for section 6110 purposes
Copy of this letter cc: