PLR 200849003: Disproportionate distributions receive inadvertent S termination relief

Plain-English summary

An S corporation made disproportionate distributions to help shareholders pay taxes on corporate income over three years. It corrected the third year's distributions and represented that it would make the necessary adjustments for the first two years. The IRS said the unequal distributions may have created a second class of stock and terminated the S election. If a termination occurred, however, the IRS treated it as inadvertent under IRC § 1362(f). It also ruled that the completed and proposed corrective payments would not themselves create a second class of stock. The corporation could retain continuous S status from its original election date if it completed all represented adjustments and its election did not otherwise terminate.

Ruling snapshot

• Question: Did disproportionate shareholder distributions terminate S status, and can corrective payments preserve continuous treatment?
• Outcome: Approved as inadvertent-termination relief, conditioned on completing the represented adjustments and otherwise maintaining a valid S election.
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200849003
Third Party Communication: None
Release Date: 12/5/2008
Date of Communication: Not Applicable
Person To Contact:
Index Number: 1361.01-04
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Telephone Number:
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Refer Reply To:
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CC:PSI:B01
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PLR-110317-08
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Date:
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September 02, 2008

Legend:

X = -------------------
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State = ----------

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

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

Year 1 = -------

Year 2 = -------

Year 3 = -------

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

This letter is in response to your request, on behalf of X, dated February 29, 2008, and supplemental materials, dated August 18, 2008, for a letter ruling that X’s disproportionate distributions did not cause X to have more than one class of stock within the meaning of section 1361(b)(1)(D) of the Internal Revenue Code.

Facts

Based on the materials submitted and representations contained within subsequent correspondence, we understand the relevant facts to be as follows. X is a
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corporation formed on Date 1 in accordance with the laws of State. On Date 2, X elected to be treated as an S corporation for federal income tax purposes. In Year 1, Year 2, and Year 3, X made disproportionate distributions to its shareholders to defray income taxes attributable to the income of X. X discovered this in Year 3, and has rectified the situation by making the necessary adjustments for Year 3. However, X has yet to make the necessary adjustments to rectify the matter for Year 1 and Year 2, but represents that X will do so.

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.

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
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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.

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 the shareholders for Year 3 does not create a second class of stock under section 1361. Furthermore, we also conclude that any corrective action taken, as described in the materials submitted for Year 1 and Year 2 will also 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), provided the necessary adjustments are made concerning Year 1, Year 2 and Year 3 as represented by X.

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 expressed or implied as to whether X otherwise qualifies as a subchapter S corporations 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.
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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,

Dianna K. Miosi

Dianna K. Miosi
Chief, Branch 1
(Passthroughs & Special Industries)

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

cc: