PLR 1045010: Inadvertent S corporation termination from shareholder loans

Plain-English summary

The IRS ruled that a corporation's S corporation election was not permanently lost even though shareholder loans and different interest rates may have created a second class of stock. The corporation had used deemed distributions and shareholder loans when its cash flow did not cover declared dividends. The IRS concluded that any resulting termination was inadvertent and allowed the corporation to continue being treated as an S corporation, provided its election was otherwise valid and not terminated for unrelated reasons. The ruling was conditioned on the corporation paying remaining additional interest for two years to its shareholders within 120 days.

Ruling snapshot

• Question: May the corporation receive relief under section 1362(f) for a possible S corporation termination caused by shareholder loans and differing interest payments?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362, and 6110(k)(3)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201045010 Third Party Communication: None
Release Date: 11/12/2010 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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------------------------------ Refer Reply To:
CC:PSI:B02
PLR-112574-10
Date:
August 05, 2010

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

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

   This responds to a letter dated March 19, 2010, and subsequent

correspondence, submitted on behalf of X by its authorized representative, requesting a
ruling under § 1362(f) of the Internal Revenue Code.

   The information submitted states that X was incorporated under the laws of State

on Date 1 and elected to be an S corporation effective Date 2. At the time of
incorporation, X’s sole shareholder was A and X’s articles of incorporation provided for
the issuance of one class of stock. In Date 3, X’s articles of incorporation were
amended to allow for two classes of stock. Except for voting rights, all other
characteristics, rights, and obligations of the two classes of stock were identical.
Subsequently, B, C, D, E, and F each acquired stock in X.

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   Each year, X declared a dividend at the end of each year in an amount equal to

X’s estimated taxable income for such year. Such dividends were pro-rata based upon the
shareholders’ proportionate ownership interest in X. However, in the years during which
X’s cash flow was inadequate to cover the amount of the declared dividend, X treated the
amount of the shortfall as a deemed distribution to its shareholders, followed by a loan
from such shareholders back to X (the Shareholder Loans). For Shareholder Loans made
in Year 1 and Year 2, X intended to pay n1% interest on Shareholder Loans from C, D, E,
and F and n2% interest on Shareholder Loans from A and B. For Shareholder Loans made
in Year 3 and thereafter, X intended to pay n3% interest on Shareholder Loans from C, D,
E, and F (except that Shareholder Loans from C beginning in Year 4 accrued at a n2%
interest rate) and n2% interest on Shareholder Loans from A and B.

  Prior to Year 6, all Shareholder loans from C, D, E, and F were repaid during the

year while Shareholder Loans from A and B (and for Year 5, from C) were often carried
forward from year to year. During Year 6 and Year 7, Shareholder Loans generally
remained outstanding for more than one year.

   During Year 5, X loaned funds to B (the B Loans), and B paid simple interest at

n2% on the B Loans. B made a significant payment on the B Loans by offsetting the
dividend otherwise due to B for Year 5, and the B Loans were fully satisfied by offsetting
the dividend due to B for Year 6.

   In Date 4, X became aware that the Shareholder Loans or the B Loans may have

created a second class of stock, thereby terminating X’s S election. On Date 5, X took
corrective action by paying the appropriate shareholders the difference between n2% and
the interest that had been actually paid on the Shareholder Loans for the period from
Year 3 to the present. Upon further review, X discovered that additional interest for Year
1 and Year 2 remains payable. X has yet to complete the necessary corrective adjustments
with respect to Year 1 and Year 2, but represents that X will do so. On Date 5, Y
purchased all of the shares in X.

   X represents that the circumstances resulting in the possible termination of X’s S

corporation election were inadvertent and not motivated by tax avoidance. X further
represents that from Date 2, X and its shareholders have filed all returns consistent with
X’s status as an S corporation. X and its shareholders have agreed to make such
adjustments consistent with the treatment of X as an S corporation as may be required by
the Secretary.

    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 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 the

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ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of
time after discovery of the circumstances resulting in the ineffectiveness or termination,
steps were taken (A) so that the corporation is a small business corporation or (B) to
acquire the 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
corporation as an S corporation) as may be required by the Secretary with respect to
such period, then, notwithstanding the circumstances resulting in the ineffectiveness or
termination, the corporation will be treated as an S corporation during the period
specified by the Secretary.

    Based solely on the facts submitted and the representations made, we conclude

that X's S corporation election may have terminated in Year 1 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). In
addition, we conclude that to the extent that X’s S corporation may have terminated as a
result of any of the other events described above, had it not already terminated in Year 1,
such termination was inadvertent within the meaning of § 1362(f). Pursuant to the
provisions of § 1362(f), X will be treated as continuing to be an S corporation from Year
1 and thereafter, provided X’s S corporation election was valid and provided that the
election was not otherwise terminated under § 1362(d) for the reasons not addressed in
this letter. This ruling is contingent upon X paying the remaining additional interest,
which X represents is still owed, for Year 1 and Year 2 to its shareholders within 120
days of this letter.

   Except as specifically set forth above, we express no opinion concerning the

federal tax consequences of the above-described facts under any other provision of the
Code. Specifically, no opinion is expressed on whether X is otherwise eligible to be
treated as an S corporation.

   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, we are sending a

copy of this letter to X’s authorized representative.

                                 Sincerely,



                                 Bradford R. Poston
                                 Senior Counsel, Branch 2
                                 Office of Associate Chief Counsel
                                 (Passthroughs & Special Industries)

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