PLR 1322036: IRS says corrective distributions did not terminate an S corporation election

Plain-English summary

The IRS ruled that an S corporation's election did not terminate when some shareholder distributions were temporarily disproportionate. The corporation's governing documents gave all shares identical rights to distributions and liquidation proceeds. The differences arose from state tax payments, changes in shareholder ownership, and later corrective distributions. The IRS said those timing and amount differences must receive appropriate tax treatment, but they did not create a second class of stock or terminate the S corporation election.

Ruling snapshot

• Question: Did disproportionate and corrective shareholder distributions create a second class of stock or terminate the S corporation election?
• Outcome: Approved, S corporation election did not terminate on the stated facts
• Key authorities: IRC §§ 1361, 1362, and 6110(k)(3); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201322036 Third Party Communication: None
Release Date: 5/31/2013 Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-00,
1361.01-04, 1362.00-00, Person To Contact:
1362.01-00 -------------------, ID No. ------------------
Telephone Number:
----------------------------------- ----------------------
------------------------------------- Refer Reply To:
---------------------------------- CC:PSI:B02
---------------------------- PLR-150476-12
Date:
January 30, 2013

LEGEND

X = -------------------------------------
------------------------

State A = --------------

State B = -----------

State C = --------------

State D = -------------------

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

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

A = ------------------------
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B = ----------------------
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C = --------------------------
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D = ------------------
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E = ---------------------
PLR-150476-12 2

              --------------------------

F = --------------
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G = -----------------------
------------------------

H = -------------------------
--------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

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

This responds to a letter dated November 26, 2012, and subsequent correspondence,
submitted on behalf of X by X’s authorized representative, requesting a ruling under
§ 1361 of the Internal Revenue Code.

The information submitted states that X was incorporated in State A on Date 1. X made
an election to be treated as an S corporation effective Date 2. Pursuant to the laws of
State A, all shareholders have equal rights to distributions and liquidation proceeds,
unless modified by the articles of incorporation. Neither X’s articles of incorporation or
bylaws modify such rights to distributions and liquidation proceeds.

Prior to Year 1, X did not make any distributions to cover the state tax liabilities of the
shareholders nor did it file any composite state income tax returns on behalf of its
shareholders.

Prior to Year 1, shareholders A and B moved from State A to State B. In Year 1, A and
B received distributions to pay their State B income tax liability for that year (the “Yr1
Distributions”). X did not take the Yr1 Distributions into account when subsequent
distributions were made to all shareholders, which resulted in disproportionate
distributions for that year. Shortly after the Yr1 Distributions had been made, X realized
the error and created a payable to shareholders A, C, D, E, F, and G (the “Distribution
Accrual”). With respect to the Yr1 Distributions, there is no written or oral agreement
between X and the shareholders to compensate shareholders for differing state tax
burdens.
PLR-150476-12 3

In Year 2, X filed composite state income tax returns in State C on behalf of all
shareholders and in State B on behalf of shareholders C, D, E, and F (but not A ,B or G,
who were State B residents) and paid the balance due. X did not make additional
distributions to each shareholder so that the distributions were pro rata when taking
into account the tax paid in connection with the State B composite state income tax
return, but X adjusted the Distribution Accrual to account for the state tax distributions,
increasing the amount due to some shareholders and decreasing the amount due to
others.

In Year 3, X filed composite state income tax returns in State C and State D on behalf of
all shareholders, but no tax was due. X filed a composite state income tax return in
State B on behalf of shareholders C, D, E, and F (but not A, B or G) and paid the
balance due. In addition, early in Year 3, X issued additional shares to certain
shareholders which caused the ownership percentages of all shareholders to change.
Following the share issuance, X made a distribution to the shareholders based on pre-
issuance ownership percentages because the distribution related to earnings
attributable to Year 2. For the remainder of Year 3, X’s distribution to shareholders
were made according to post-issuance ownership percentages. At the conclusion of
Year 3, the Distribution Accrual remained unchanged from Year 2.

In Year 4, X paid out the remaining balance in the Distribution Accrual to the appropriate
shareholders. In addition, X paid additional amounts to certain shareholders to account
for the fact that the Distribution Accrual account was not appropriately adjusted for the
Year 3 composite income tax return payment to State B. Also in Year 4, H became a
shareholder of X, which caused the ownership percentages of all shareholders to
change. X subsequently made several distributions that were not pro rata because X
made the distributions based on the ownership percentages of the shareholders prior
to the admittance of H as a shareholder. However, once the disproportionate
distributions were discovered in Year 4, X made additional distributions such that all
distributions in Year 4 were pro rata.

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 such year.

Section 1361(b)(1)(D) provides that, for purposes of subchapter S, the term “small
business corporation” means a domestic corporation which is not an ineligible
corporation and which does not, among other things, have more than one class of
stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides, in part, 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 stock
PLR-150476-12 4

among shares of stock of a corporation are disregarded in determining whether a
corporation has more than one class of stock.

Section 1.1361-1(l)(2)(i) provides, in part, 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). 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.

Based on the facts and representations submitted by X, we conclude that because X’s
stock has identical distribution and liquidation rights under its governing provisions, the
difference in timing between X’s disproportionate distributions to some of the
shareholders and X’s corrective distributions to certain shareholders do not cause X to
have more than one class of stock for purposes of § 1361(b)(1)(D). However, such
disproportionate and corrective distributions must be given appropriate tax effect.
Under these circumstances, we conclude that X’s S corporation election did not
terminate because of the disproportionate and corrective distributions to the
shareholders.

Except for the specific ruling above, we express or imply no opinion concerning the
federal income tax consequences of the facts of this case under any other provision of
the Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an
S corporation.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent. Under a 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
                                   (Passthroughs & Special Industries)

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