PLR 1351017: S corporation status preserved after a possible second class of stock

Plain-English summary

An LLC that had elected S corporation treatment discovered that its operating agreement and slightly disproportionate capital accounts might have created more than one class of stock. The IRS concluded that any resulting ineffectiveness or termination of the S corporation election was inadvertent. After the owners adopted corrective operating agreement provisions, the IRS ruled that the correction did not create a second class of stock and that the entity would continue to be treated as an S corporation from its original effective date, assuming the election was not otherwise terminated.

Ruling snapshot

• Question: Can an S corporation election continue after operating agreement provisions may have created a second class of stock?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362; Treas. Reg. §§ 1.1361-1, 1.1362-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201351017 Third Party Communication: None
Release Date: 12/20/2013 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------------ --------------, ID No. ------------------
----------------------------------------------- Telephone Number:
--------------------------------- ----------------------
--------------------------------------- Refer Reply To:
CC:PSI:B02
PLR-133808-13
Date:
August 16, 2013

LEGEND

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

State = -------

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

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

Date 3 = ------------------------

Date 4 = -------------------

Date 5 = --------------------

Year = -------

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

This letter is in response to your request, dated July 25, 2013, on behalf of X, seeking
relief under § 1362(f) of the Internal Revenue Code.

FACTS

Based on the materials submitted and representations within, we understand the
relevant facts to be as follows. X was organized as a limited liability company under the
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laws of State on Date 1. X made elections to be treated as an association taxable as a
corporation and to be treated as an S corporation effective Date 2.

At the time of its organization, X represents that its owners entered into an Operating
Agreement (the “Original Operating Agreement”). X is unable to locate a copy of this
agreement. X arranged for a new operating agreement to be entered into effective as of
Date 3 (the “Restated Operating Agreement”).

Section 6.1(a) of the Restated Operating Agreement provides that “[n]et Cash Flow
From Operations and Net Cash Flow From Sales, Refinancings and Other Extraordinary
Items shall be distributed to the members at such times and in such amounts as
determined by the managers; provided, however, that the Company shall distribute Net
Cash Flow From Operations to the members at least annually. All cash flow
distributions shall be in proportion to the members’ Profit-Sharing Percentages unless
all members otherwise consent.”

Section 6.1(b) of the Restated Operating Agreement provides that “[i]n the case of the
liquidation or termination of the Company, distributions shall be made in accordance
with Article XI hereof.”

Section 11.4(a) of Article XI, in relevant part, provides that “[a]ll cash and other property
remaining for distribution to members pursuant to Section 11.3 following satisfaction of
all debts and liabilities after an Event of Termination shall be divided among and
distributed to the members in accordance with their positive capital accounts, after
giving effect to all contributions, distributions, and allocations for all periods. If any
member has a deficit Capital Account balance (after giving effect to all contributions,
distributions, and allocations for all period [sic]), such member shall have no obligation
to make any contribution to the capital of the Company with respect to such deficit, and
such deficit shall not be considered a debt owed to the Company or to any other person
for any purpose whatsoever. The foregoing provision and the other provisions of this
Agreement relating to distributions are intended to comply with Regulation Section
1.704-1(b)(2)(ii)(b) and shall be interpreted and applied in a manner consistent with
such regulation.”

Exhibit A to the Restated Operating Agreement has provisions relating to the allocation
of profits and losses and the maintenance of capital accounts. While these provisions
were included in contemplation of X being treated as a partnership, their applicability
was not limited to such being the case. Thus, such provisions applied during the period
of time in which X intended to be treated as an S corporation for U.S. federal income tax
purposes.

X maintains a separate capital account for each owner on its books and records. These
capital accounts are not proportionate based on each owner’s ownership percentage in
X, although the disproportionality is slight. X believes the disproportionality relates to an
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adjusting journal entry in the year following the S election, but is unable to locate an
explanation for the entry. However, X represents that the disproportionate capital
accounts were not as a result of any transaction that had as a principal purpose
circumvention of the small business corporation one class of stock requirement in
§ 1361(b)(1)(D).

On Date 4, an unrelated third party (the “Purchaser”), acquired all of the outstanding
interests in X. Purchaser, who, together with the owners, intends to file an election
under § 338(h)(10) with respect to its acquisition of X’s member interests. Prior to the
acquisition, during the purchaser’s due diligence, the Purchaser’s advisors reviewed the
Restated Operating Agreement and the books and records of X and advised the
Purchaser that X could be viewed has having more than one class of stock for purposes
of the small business corporation requirement of § 1361(b)(1)(D). Specifically, the
purchaser’s advisors noted that because the Restated Operating Agreement provided
for liquidating distributions to the owners based on each owner’s capital account
balance and that the capital account balances were disproportionate, each outstanding
member interest in X did not have identical rights to liquidation proceeds. Furthermore,
the Purchaser’s advisors also noted that because the Original Operating Agreement
could not be located, it was not possible to determine if X satisfied the one class of
stock requirement at the time it filed its S election.

To eliminate the potential second class of stock X and the owners entered into a
Second Restated Operating Agreement effective as of Date 5.

Section 11.4(a) of the Second Restated Operating Agreement provides that “[f]or so
long as the Company maintains its election to be classified as an association taxable as
a corporation for federal income tax purposes pursuant to Treasury Regulation Section
301.7701-3(c) (including, without limitation, taxation as an “S Corporation” within the
meaning of Section 1361 and 1362 of the Code), all cash and other property remaining
for distribution to members pursuant to Section 11.3 following satisfaction of all debts
and liabilities after an Event of Termination shall be divided among and distributed to
the Members pro rata in proportion to their respective membership units of the
Company.”

Section 11.4(b) of the Second Restated Operating Agreement provides that “[t]his
Section 11.4(b) shall apply only if, at the time of the dissolution and liquidation of the
Company, the Company is classified as a partnership for federal income tax purposes.
In such case, all cash and other property remaining for distribution to members pursuant
to Section 11.3 following satisfaction of all debts and liabilities after an Event of
Termination shall be divided among and distributed to members in accordance with their
positive capital accounts, after giving effect to all contributions, distributions, and
allocations for all periods. If any member has a deficit capital account balance (after
giving effect to all contributions, distributions, and allocations for all period [sic]), such
member shall have no obligation to make any contribution to the capital of the Company
PLR-133808-13 4

with respect to such deficit, and such deficit shall not be considered a debt owed to the
Company or to any other person for any purpose whatsoever. The foregoing provision
and the other provisions of this Agreement relating to distributions are intended to
comply with Treasury Regulation Section 1.704-1(b)(2)(ii)(b) and shall be interpreted
and applied in a manner consistent with such regulation.”

In accordance with § 1362(f) and § 1.1362-4, X and each person who has been a
shareholder of X at any time after Date 4 through the date of the ruling request have
consented to any adjustments as may be required by the Secretary.

X requests a ruling that if certain provisions of X’s operating agreements caused it to
have more than one class of stock for purposes of § 1361(b)(1)(D), then the resulting
ineffectiveness or subsequent termination of its S election was inadvertent within the
meaning § 1362(f). Furthermore, notwithstanding the potential invalidity or termination
of its S election, pursuant to § 1362(f), X will be treated an S corporation from Date 2
and thereafter.

LAW AND ANALYSIS

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

Section 1.1361-1(I)(1) of the Income Tax Regulations provides that a corporation is
generally 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.

Section 1.1361-1(I)(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.
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.
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Section 1.1361-1(I)(2)(iii)(B) provides that bona fide agreements to redeem or purchase
stock at the time of death, divorce, disability, or termination of employment are
disregarded in determining whether a corporation's shares of stock confer identical
rights.

Section 1362(d)(2)(A) provides that an election under § 1362(a) will 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.

Section 1362(d)(2)(B) provides that the termination shall be effective on and after the
date of cessation.

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 such ineffectiveness or termination were
inadvertent, (3) no later than a reasonable period of time after discovery of the
circumstances resulting in such ineffectiveness or termination, steps were taken (A) so
that the corporation is a small business corporation, or (B) to acquire the required
shareholder consents, and (4) the corporation, and each person who was a shareholder
in 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 such ineffectiveness or termination, such
corporation shall be treated as an S corporation during the period specified by the
Secretary.

CONCLUSION

Based on the information submitted and the representations made, we conclude that X's
S corporation election may have been ineffective or subsequently terminated because X
may have had more than one class of stock. However, we conclude that, if X's S
election was ineffective or subsequently terminated, such ineffectiveness or termination
was inadvertent within the meaning of § 1362(f) of the Code.

Further, we conclude that the corrective action taken by X and its shareholders does not
create a second class of stock under § 1361. Consequently, we rule that X will be
treated as continuing to be an S corporation from Date 2, and thereafter, provided that
X's S election otherwise is not terminated under § 1362(d).
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Except as specifically ruled upon above, no opinion is expressed as to the federal
income tax consequences of the facts described above under any other provision of the
code. In particular, no opinion is expressed or implied as to whether X otherwise
qualifies as a subchapter S corporations under § 1361.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and are accompanied by a perjury statement executed by an
appropriate party. While this office has not verified any of the material submitted in
support of this request, it is subject to verification on examination.

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.

In accordance with the Power of Attorney on file with this office, a copy of this letter
ruling will be sent to the taxpayer representative.

                                   Sincerely,




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

Enclosure (1)
Copy of Letter for § 6110 purposes