IRS preserves S-corporation status after disproportionate distributions

Plain-English summary

The IRS ruled that disproportionate distributions by an S corporation did not create a prohibited second class of stock because the corporation's governing documents and binding agreements gave all shares identical distribution and liquidation rights. The corporation's S election therefore did not terminate under section 1362(d)(2). The ruling required the corporation and one shareholder to make corrective distributions and payments so that distributions became proportionate to the shareholders' interests from the corporation's original S-election date. The ruling would be void if those corrective steps were not completed within 120 days.

Ruling snapshot

• Question: Whether disproportionate distributions created a second class of stock and terminated the corporation's S election.
• Outcome: Approved, subject to corrective distributions and payments.
• 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: 201234001
Third Party Communication: None
Release Date: 8/24/2012
Date of Communication: Not Applicable
Person To Contact:
Index Number: 1361.01-04
----------------------------, ID No. ---------------
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Telephone Number:
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--------------------------------------------------------------- -------------------- Refer Reply To:
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CC:PSI:02
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PLR-100553-12
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Date:
------------------------------------------ May 07, 2012

Legend

X = ------------------------------------------------------------------------------------------------------
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State = ----------------
D1 = -------------------------
A = ----------------------
B = ---------------
a = ------
B = ------

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

This responds to a letter dated December 23, 2011 and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting a ruling relating to X’s status as an S corporation under §§ 1361 and 1362 of the Internal Revenue Code.

Facts

The information submitted states that X was incorporated under the laws of State and made an election to be treated as an S corporation effective D1. A and B are the only shareholders of X. A owns a and B owns b of the stock of X, and X made disproportionate distributions to A and B during the course of its operations.

X represents that each share of X has identical rights to liquidation proceeds and distributions. No provision exists in the governing documents, regulations, or by-laws that vary these rights. X also represents that no other binding agreement exists that
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vary these rights. In addition, X represents that it will take remedial steps to correct the disproportionate distribution that will result in distributions proportionate to A and B’s respective interests in X since its inception as an S corporation. Finally, X represents that it always intended to be an S corporation since its inception.

X represents that at all relevant times, X and its shareholders treated X as an S corporation and filed their tax returns accordingly. X and its shareholders have agreed to make any adjustments the Commissioner may require consistent with the treatment of X as an S corporation.

Law and Analysis

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 § 1.1362(a) is in effect for such year.

Section 1361(b)(1) provides that the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 100 shareholders, (b) have as a shareholder a person (other than an estate, a trust described in § 1361(c)(2), or an organization described in § 1362(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides that a corporation that has more than one class of stock does not qualify as a small business corporation. 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 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, by laws, 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
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principal purpose of the agreement is to circumvent the one class of stock requirement of § 1361(b)(1)(D) and § 1.1361-1(l). Although a corporation is not treated as having more than once 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 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361(b)(3), (4), and (5) (relating to restricted stock, deferred compensation plans, and straight debt), in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds, all outstanding shares of stock of a corporation are taken into account.

Section 1362(a) provides, in part, that a small business corporation may elect to be an S corporation. 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 1st taxable year for which the corporation is an S corporation such corporation ceases to be a small business corporation.

Conclusion

Based solely on the facts submitted and representations made, we conclude that the disproportionate distributions X made to A and B did not create a second class of stock for purposes of § 1361(b)(1)(D). Thus, we conclude that X’s S corporation election did not terminate under § 1.1362(d)(2)(A) and that X will be treated as an S corporation beginning on D1 and thereafter, provided X’s S corporation election was valid and was not otherwise terminated under § 1362(d). This ruling is contingent upon X and B making corrective distributions and payments so that each shareholder has received distributions proportionate to their interests in X from D1 and thereafter, within 120 days of the date of this letter. Failure to make such corrective distributions and payments will render this ruling void.

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. 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. Pursuant to a
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power of attorney on file, a copy of this letter is being sent to X’s authorized representative.

Sincerely,

Bradford R. Poston
Senior Counsel, Branch 2
(Passthroughs & Special Industries)

Enclosures (2)
Copy of this Letter
Copy for § 6110 purposes

cc: