PLR 201337001: IRS grants inadvertent S election termination relief

Plain-English summary

An S corporation implemented an employee equity compensation arrangement through a newly formed entity and an amended operating agreement that created a new class of stock. The corporation later revoked that agreement and adopted a replacement. The IRS concluded that the resulting termination of the corporation's S election was inadvertent under section 1362(f). The corporation would continue to be treated as an S corporation from the termination date, provided it otherwise remained eligible and the election was not terminated for another reason.

Ruling snapshot

• Question: Was the corporation's S election termination caused by the equity compensation arrangement inadvertent?
• Outcome: Approved, with continued S corporation treatment subject to the stated conditions.
• Key authorities: IRC §§ 1361 and 1362(d) and (f); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201337001
Third Party Communication: None
Release Date: 9/13/2013
Date of Communication: Not Applicable
Index Number: 1362.02-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:02
PLR-103878-13
Date:
May 28, 2013

Legend
X = -------------------------------------------------------------------------------------------------
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State = ---------
Date 1 = ------------------------
Date 2 = --------------------------
Date 3 = ----------------------

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

This responds to a letter dated January 17, 2013, and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

The information submitted states that X was formed in State on Date 1. X made an election to be treated as an association taxable as an S corporation under § 1362 effective Date 1. X’s management decided to implement an equity-based compensation plan for its employees in the form of a grant of traditional profits interests in X. Rather than grant profits interests in X directly to its employees, X decided to grant one profits interest to a newly formed entity and grant membership interests in that entity to X’s employees. The members of X executed a Second Amended and Restated Limited Liability Company Operating agreement effective Date 2 creating a new class of stock implementing the equity-based compensation profits plan.

The new class member did not make a capital contribution to X nor did the new class member receive distributions from X. On Date 3, X executed an agreement revoking the Second Amended and Restated Agreement. Also on Date 3, the members executed a Third Amended and Restated Limited Liability Company Operating Agreement.
PLR-103878-13
2

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.

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) 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 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 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 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, 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).

Section 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361-1(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.
PLR-103878-13
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Section 1362(f) provides in part that if (1) an election under § 1362(a) by any corporation was terminated under § 1362(d), (2) the Secretary determines that the circumstances resulting in the termination were inadvertent, (3) no later than a reasonable period of time after the discovery of the circumstances resulting in the termination, steps were taken so that the corporation for which the termination occurred is a small business corporation, and (4) the corporation for which the termination occurred, and each person who was a shareholder in such corporation at any time during the period of inadvertent termination of the S election, agrees to makes 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 termination, the corporation is treated as an S corporation during the period specified by the Secretary.

Conclusion

Based solely on the facts submitted and representations made, we conclude that X’s termination on Date 2 was inadvertent within the meaning of § 1362(f). We further conclude hold that, pursuant to the provisions of § 1362(f), X will be treated as an S corporation from Date 2 and thereafter provided that provided X is otherwise eligible to be an S corporation and provided that the election was not otherwise terminated under
§ 1362(d).

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 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