PLR 1030018: S corporation status preserved after stock-class and passive-income issues

Plain-English summary

The IRS granted a corporation relief under section 1362(f) after identifying two possible problems with its S corporation status. Its stock had disparate preemptive rights that could have created a second class of stock, and it had accumulated earnings and profits plus passive investment income above the statutory limit for three consecutive years. The corporation removed the preemptive rights, treated distributions as dividends from accumulated earnings and profits, and agreed to make any required adjustments. The IRS treated the S election as effective from the requested date and treated the later termination as inadvertent, subject to a required payment and delivery of the ruling by the specified deadline. The ruling did not express an opinion on the corporation's general eligibility, the validity of its election apart from the stated relief, or whether its income was passive investment income.

Ruling snapshot

• Question: Could the corporation receive relief for a potentially invalid S election and its later termination?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(d), 1362(f), 1368, and 1375

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201030018 Third Party Communication: None
Release Date: 7/30/2010 Date of Communication: Not Applicable
Person To Contact:
---------------------------, ID No. -------------
Telephone Number:
--------------------
----------------------- Refer Reply To:
------------------- CC:PSI:B01
--------------------------------- PLR-149762-09
Date:
April 22, 2010

LEGEND
X = ---------------------------------------------------------------------------------------------------------------

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

Date1 = ----------------------

Date2 = ----------------------

Date3 = ----------------------

Date4 = ---------------------------

Date5 = ------------------

a = ---------------

b = -------------

Year 1 = -------

Year 2 = -------

Year3 = -------

Year4 = -------

Year5 = -------
PLR-149762-09 2

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

   This responds to a letter dated -----------------------, and subsequent

correspondence, submitted on behalf of X by X's authorized representative, requesting
inadvertent invalid election relief and inadvertent termination relief under § 1362(f) of the
Internal Revenue Code.

Facts

    According to the information submitted, X was incorporated under the laws of

State on Date1. X elected to be treated as an S corporation for Federal tax purposes
effective Date2. At that time, X had two classes of stock outstanding, which conferred
disparate preemptive rights. The preemptive rights were never exercised or
exercisable, and on Date4, X amended its articles of incorporation to eliminate the
preemptive rights.

    Also at the time of the S election, X had C corporation accumulated earnings and

profits (“CE&P”) of $a. For each of the consecutive years of Year1, Year2, and Year3,
X had passive investment income in excess of 25 percent of its yearly gross receipts.
As a result, X’s S election would have terminated on Date3 if it had been valid.

   In the course of preparation for X’s Year4 tax return, X became aware that its S

election had terminated on Date3. To correct the error, X made an election under
§ 1.1368-1(f) of the Income Tax Regulations to treat all Year4 distributions as dividends
paid from X’s accumulated CE&P. X represents that in Year5, X distributed as
dividends the remainder of its accumulated CE&P.

   X represents that the circumstances resulting in the potential invalidity of its S

election, as well as the termination on Date3, were inadvertent, and that since Date2 X
and its shareholders have filed returns consistent with X’s status as an S corporation
(other than with respect to its passive investment income and the tax under § 1375). X
and its shareholders agree to make adjustments (consistent with the treatment of X as
an S corporation) as might be required by the Secretary.

Rulings Requested

1. To the extent that X's S corporation election on Date2 was ineffective, X requests a
   ruling under § 1362(f) that X will be treated as being an S corporation beginning on
   Date2 and thereafter;
   PLR-149762-09 3

2. X requests a ruling that the termination of its S election on Date3 will be treated as an
   inadvertent termination under § 1362(f).

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 such year.

   Section 1361(b)(1) defines a “small business corporation” as a domestic

corporation which is not an ineligible corporation which does not (A) have more than
100 shareholders, (B) have as a shareholder a person (other than an estate, and a trust
described in subsection (c)(2), or an organization described in subsection (c)(6)) who is
not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than
1 class of stock.

   Section 1.1361-1(l)(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 1362(d)(2)(A) provides that an election under § 1362(a) shall be

terminated whenever (at any time on or after the 1st day of the taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

   Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be

terminated whenever the corporation has accumulated earnings and profits at the close
of each of three consecutive taxable years, and has gross receipts for each of such
years more than 25 percent of which are passive investment income. Section
1362(d)(3)(A)(ii) provides that any termination under § 1362(d)(3) shall be effective on
and after the first day of the first taxable year beginning after the third consecutive
taxable year referred to in § 1362(d)(3)(A)(i).

    Section 1362(f) provides that if (1) an election under § 1362(a) by any

corporation (A) was not effective for the taxable year for which it was made (determined
without regard to § 1362(b)(2)) by reason of a failure to meet the requirements of
§ 1361(b) or to obtain shareholder consents, or (B) was terminated under § 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 event resulting in the 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 of the corporation at any time during the period specified pursuant to
§ 1362(f), agrees to make such adjustments (consistent with the treatment of the
PLR-149762-09 4

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, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

  Section 1368(c) provides rules for determining the source of distributions made by an S corporation having accumulated earnings and profits with respect to its stock. Section 1368(e)(3) and § 1.1368-1(f)(2) provide that an S corporation may, with the consent of all its affected shareholders, elect to distribute earnings and profits first.

   Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or

part of its accumulated earnings and profits through a deemed dividend. If an S
corporation makes the election provided in § 1.1368-1(f)(3), the S corporation will be
considered to have made the election under § 1368(e)(3) and § 1.1368-1(f)(2) to
distribute earnings and profits first.

   Section 1375 imposes a tax on the income of an S corporation that has

accumulated earnings and profits at the close of a taxable year, and that has gross
receipts more than 25 percent of which are passive income (within the meaning of
§ 1362(d)(3)).

Conclusion

   Based solely on the information submitted and the representations made, we

conclude that, to the extend the shares of X subject to the preemptive right constitute a
second class of stock, any invalidity of X’s S election as a result of the preemptive right
constitutes an inadvertent invalidity within the meaning of § 1362(f).

    Furthermore, we conclude that X’s S corporation election, if valid, would have

terminated on Date3 under § 1362(d)(3)(A) because X had earnings and profits at the
close of each of three taxable years, and had gross receipts for each of those taxable
years more than 25 percent of which were passive investment income. We also
conclude that this termination of X’s S election on Date3 was an inadvertent termination
within the meaning of § 1362(f).

     Therefore, we conclude that X will be treated as an S corporation from Date2 and

thereafter, including on and after Date3, provided that X's S corporation election was
otherwise valid and was not otherwise terminated under § 1362(d). This letter ruling is
subject to the following condition: as an adjustment under § 1362(f)(4), a payment of $b
and a copy of this letter must be sent to the following address: Internal Revenue
Service, Cincinnati Service Center, 201 West Rivercenter Blvd., Covington KY 41011,
Stop 31, Terri Lackey, Manual Deposit. This payment must be sent no later than Date5.
If this condition is not met, then this ruling is null and void. Furthermore, if this condition
PLR-149762-09 5

is not met, X must send notification that its S election has terminated to the service
center with which X’s S election was filed.

   Except as specifically set forth above, no opinion is expressed concerning the

federal tax consequences of the facts described above under any other provision of the
Code. Specifically, no opinion is expressed regarding X's eligibility to be an S
corporation or the validity of its S corporation election. Further, no opinion is expressed
as to whether X's income was passive investment income under § 1362(d)(3)(C).

   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.

   Pursuant to a power of attorney on file with this office, a copy of this letter is

being sent to X.

                                       Sincerely,

                                          /s/

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

Enclosures (2)

Copy of this letter
Copy of this letter for § 6110 purposes

cc: