PLR 201132013: IRS preserves an S corporation election after a possible second-class-of-stock problem

Plain-English summary

The IRS ruled that a limited liability company that had elected S corporation treatment did not invalidate or terminate its election because of two earlier operating agreements. One later agreement changed how some distributions would be calculated based on members' work hours and years of service, potentially creating more than one class of stock. The company represented that all actual distributions had been made according to percentage interests and that no distributions used the work-based formulas. The IRS concluded that any resulting termination would have been inadvertent and allowed the company to be treated as an S corporation continuously, subject to the stated conditions and the election otherwise being valid.

Ruling snapshot

• Question: Did the agreements invalidate or terminate the company's S corporation election, and could inadvertent termination relief apply?
• Outcome: approved
• 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: 201132013
Third Party Communication: None
Release Date: 8/12/2011
Date of Communication: Not Applicable
Person To Contact:
Index Number: 1362.04-00
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Telephone Number:
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CC:PSI:B02
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PLR-145356-10
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Date:
May 03, 2011

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

Date = ----------------------
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Dear -------------------:

This responds to a letter dated October 28, 2010, and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue Code.
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The information submitted states that X is a limited liability company formed in State on Date 1. X made an election to be treated as an association taxable as a corporation and an S corporation election under § 1362 effective Date 2. The members of X executed an agreement effective Date 3 and an agreement effective Date 4 (collectively, the “Agreement”) that provided that each member that contributed capital to X would receive membership, percentage, and voting interests, that those membership interests would be of one class and that all distributions were to be made according to the members’ percentage interests in X.

On Date 5, the members adopted an amendment to the Agreement that provided that non-liquidating distributions would be made according to a member’s percentage interest multiplied by the average base hours the member worked for X during the calendar year and that liquidating distributions would be made according to the member’s percentage interest multiplied by the number of years the member had worked for X.

On Date 6, the members adopted an amendment to the Agreement that provided that all distributions would be made according to the members’ percentage interests in X.

Since Date 2, all distributions to the members of X have been in proportion to their percentage interests at the time of the distribution, and no distributions have been made based upon the hours a member worked. X has not made any liquidating distributions based on a member’s length of service to 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 1361(a) 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 the term “small business corporation” means a domestic corporation that, among other things, does not have more than one class of stock. Accordingly, S corporations may not have more than one class of stock.

Section 1.1361-1(l)(1) provides that, except as provided in § 1.1361-1(l)(4) (relating to instruments, obligations, or arrangements treated as a second class of stock), a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation
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proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock. Thus, if all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.

Section 1.1361-1(l)(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 of § 1361(b)(1)(D) and § 1.1361-1(l).

Section 1.1361-1(l)(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 distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the one class of stock requirement of § 1361(b)(1)(D) and § 1.1361-1(l), and (2) 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(l)(2)(iii)(C)(1) 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 optional adjustments).

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 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
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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 information submitted and the representations made, we conclude that X’s S corporation election on Date 2 was not invalid due to the provisions of the Date 3 agreement and that the election did not terminate on Date 4. We further conclude that X’s S corporation election may have terminated on Date 5 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). Accordingly, pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation from Date 2 and thereafter, provided X’s S election was valid and was not otherwise terminated under § 1362(d).

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.

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,

Melissa C. Liquerman
Chief, Branch 2
Office of Associate Chief Counsel
(Passthroughs & Special Industries)

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