PLR 200705004: Unequal state-tax distributions receive inadvertent S termination relief

Plain-English summary

An S corporation paid state taxes for shareholders and handled refunds differently for participants in composite returns and other shareholders. The resulting unequal distributions raised concern that it might have created a prohibited second class of stock. The company made corrective distributions with interest and began treating shareholder tax payments as deemed distributions in testing proportionality. The IRS ruled that any S termination caused by these practices was inadvertent and granted relief under section 1362(f). S treatment would continue from the original election date unless otherwise terminated, with shareholders required to apply the S income, basis, and distribution rules. The IRS did not determine whether the company otherwise qualified as an S corporation.

Ruling snapshot

• Question: Can possible S termination from unequal shareholder state-tax payments and refunds be relieved after correction?
• Outcome: Approved: relief for any inadvertent termination caused by the described practices.
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(f), 1366, 1367, 1368; Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200705004
Third Party Communication: None
Release Date: 2/2/2007
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
--------------------------------------
-----------------, ID No. -------------
----------------------------------
Telephone Number:
-----------------------------
---------------------
-------------------------
Refer Reply To:
CC:PSI:B01
PLR-119257-06
-
Date: October 17, 2006

LEGEND

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

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

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

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

Year = -------

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

This responds to a letter dated March 29, 2006, submitted on behalf of X, requesting a ruling under § 1362(f) of the Internal Revenue Code.

FACTS

The information submitted states that X was incorporated on Date 1 in accordance with the laws of State. X elected to be an S corporation effective Date 2. Since X’s election to be an S corporation, X has filed composite state income tax returns in certain states on behalf of its eligible shareholders. X has also paid the composite tax due on those returns on behalf of the shareholders. Prior to Year, X received and kept state tax refunds with respect to composite returns, while individual shareholders who did not participate in the composite return kept any refunds even though some of those taxes were initially paid by X. These practices have resulted in X making disproportionate distribution to certain shareholders. X determined that the disproportionate distributions
PLR-119257-06
2

may have created a second class of stock in violation of the one class of stock requirement of § 1361(b)(1)(D).

X represents that it did not intend to create a second class of stock or to terminate X’s S corporation election and that the circumstances resulting in the possible termination of the election were not motivated by tax avoidance or retroactive tax planning. X represents that it has taken the following corrective actions: (1) Corrective distributions were made to affected shareholders so that each shareholder received the correct proportion of distributions for the years at issue based on the weighted average ownership percentages for each year, including interest; (2) Since Year, X has been treating state tax payments made on behalf of shareholders as deemed distributions when determining whether distributions have been made proportionately. The amount of a shareholder’s total distribution for a year related to state tax payments is disclosed on each shareholder’s Form K-1. X will continue this treatment in future years. 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 § 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"). 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.

Section 1362(d)(2)(A) provides that an election under § 1362(a) will be terminated whenever (at any time on or after the first day of the first taxable year for which the corporation is an S corporation) such corporation ceases to be a small business
PLR-119257-06
3

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 § 1362(a) by any corporation was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in such termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in such termination, steps were taken so that the corporation is a small business corporation, and (4) the corporation, and each person who was a shareholder in the corporation at any time during the period specified pursuant to § 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 termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

Based solely 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 termination was inadvertent within the meaning of § 1362(f). Therefore, 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 is not otherwise terminated under § 1362(d). X’s shareholders, in determining their respective income tax liabilities during the termination period and thereafter, must include their pro rata share of the separately stated computed items of income or loss of X as provided in § 1366, make any adjustments to basis provided in § 1367, and take into account any distributions made by X as provided in § 1368.

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. Specifically, no opinion is expressed or implied as to whether X otherwise qualifies as an S corporation under § 1361.

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.
PLR-119257-06
4

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

Sincerely,

Audrey W. Ellis
Senior Counsel, Branch 1
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

cc: ----------------------------------
------------------------------------------------------------------------------------
--------------
---------------------------------------------
-------------------------
----------------------

-------------------
----------------------------------------
-------------------------------------
-------------------------------

--------------------------
------------------------------------
-------------------------