Corporation kept S status after ineligible shareholders and uneven distributions

Plain-English summary

An S corporation's election terminated when stock was transferred to an LLC, an ineligible shareholder. Stock was also transferred to a trust whose income beneficiary did not make the required qualified subchapter S trust election. The LLC and trust later transferred their shares to eligible shareholders, and the corporation represented that the failures were inadvertent. The IRS allowed the corporation to be treated continuously as an S corporation and treated the LLC members as proportionate owners and the trust as a QSST during the relevant period. The IRS also ruled that disproportionate distributions did not create a second class of stock because the governing provisions gave all shares identical distribution and liquidation rights. That part of the relief was conditioned on corrective distributions within 120 days, with appropriate tax treatment for both the original and corrective distributions.

Ruling snapshot

• Question: Could the corporation retain continuous S status after stock was held by an ineligible LLC and a trust without a timely QSST election, and after disproportionate shareholder distributions?
• Outcome: Approved. The IRS granted inadvertent-termination relief and found no second class of stock, subject to timely corrective distributions.
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201426009 Third Party Communication: None
Release Date: 6/27/2014 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------ ---------------------, ID No. ----------------
------------------------------------------------ Telephone Number:
---------------------------------------------- --------------------
------------------------------------------- Refer Reply To:
-------------------------------------- CC:PSI:B03
PLR-138913-13
Date:
February 24, 2014

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

State = --------------------

LLC = ------------------------

Members = --------------------

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

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

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Trust = ------------------------------------

D1 = --------------------------

D2 = ------------------
PLR-138913-13 2

D3 = ------------------------

D4 = ------------------

D5 = --------------------------

Period = -------------------------------------

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

   This letter responds to a letter dated August 30, 2013, and subsequent

correspondence, submitted on behalf of X requesting a ruling under § 1362(f) of the
Internal Revenue Code (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. X’s S corporation
election was terminated on D2, when stock in X was transferred to LLC, an ineligible
shareholder. In addition, X stock was transferred to Trust on D3. X represents that
Trust qualified as a qualified subchapter S trust (“QSST”) under § 1361(d)(3), but its
income beneficiary, who died on D4, failed to make a QSST election. On D5, LLC and
Trust transferred the X stock they held to eligible shareholders.

   X represents that the termination was not motivated by tax avoidance or

retroactive tax planning. X and its shareholders have agreed to make any adjustments
that the Commissioner may require, consistent with the treatment of X as an S
corporation.

   Finally, during Period, X made disproportionate distributions to its shareholders.

X represents that under State law, all of X’s stock have identical rights to distribution
and liquidation proceeds. No provision in X’s articles of incorporation, bylaws, or any
other governing instruments altered those rights. X further represents that there is no
agreement, written or oral, that any shareholder would be entitled to a preference
regarding X’s distribution or liquidation proceeds. X represents that it will make
corrective distributions to rectify the disproportionate distributions made during Period to
its shareholders.

                                     LAW AND ANALYSIS

PLR-138913-13 3

    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) defines a “small business corporation” as 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 § 1361(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 1361(d)(1) provides that a QSST whose beneficiary makes an election

under § 1361(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the
QSST’s beneficiary will be treated as the owner (for purposes of § 678(a)) of that
portion of the QSST’s S corporation stock to which the election under § 1361(d)(2)
applies. Under § 1361(d)(2)(A), a beneficiary of a QSST may elect to have § 1361(d)
apply. Under § 1361(d)(2)(D), this election will be effective up to 15 days and two
months before the date of the election.

     Section 1361(d)(3) provides that for purposes of § 1361(d), the term “qualified

subchapter S trust” means a trust (A) the terms of which require that -- (i) during the life
of the current income beneficiary, there shall be only one income beneficiary of the
trust; (ii) any corpus distributed during the life of the current beneficiary may be
distributed only to such beneficiary; (iii) the income interest of the current income
beneficiary in the trust shall terminate on the earlier of such beneficiary’s death or the
termination of the trust; and (iv) upon the termination of the trust during the life of the
current income beneficiary, the trust shall distribute all of its assets to that beneficiary;
and (B) all of the income (within the meaning of § 643(b)) of which is distributed (or
required to be distributed) currently to one individual who is a citizen or resident of the
United States.

   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. Section 1362(d)(2)(B) provides that any termination under § 1362(d) 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 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,
PLR-138913-13 4

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
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.

   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
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.

    In § 1.1361-1(l)(2)(vi), Example 2 (Distributions that differ in timing), S, a

corporation, has two equal shareholders, A and B. Under S’s bylaws, A and B are
entitled to equal distributions. S distributes $50,000 to A in the current year, but does
not distribute $50,000 to B until one year later. The circumstances indicate that the
difference in timing did not occur by a binding agreement relating to distribution or
liquidation proceeds. The example concludes that under § 1.1361-1(l)(2)(i), the
difference in timing of the distributions to A and B does not cause S to be treated as
having more than one class of stock. However, § 7872 or other recharacterization
principles may apply to determine the appropriate tax consequences.

                                    CONCLUSIONS

   Based solely on the facts submitted and the representations made, we conclude

that the termination of X’s S corporation election on D2 was inadvertent within the
meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as
continuing to be an S corporation from D2 and thereafter, provided X’s S corporation
PLR-138913-13 5

election was valid and provided that the election was not otherwise terminated under
§ 1362(d). In addition, from D2 through D5, Members shall be treated as the owners of
X stock in proportion to their ownership interests in LLC, and Trust will be treated as a
QSST during the period for which it held X stock.

    In addition, based solely on the facts submitted and representations made, we

conclude that because X has identical distribution and liquidation rights under its
governing provisions, the difference in timing between X’s disproportionate distributions
and the corrective distributions that X will make do not cause X to be treated as having
more than one class of stock for purposes of § 1361(b)(1)(D). However, X’s
disproportionate distributions 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 distributions and the corrective distributions
that X will make. This ruling is contingent upon X making corrective distributions so that
each shareholder receives 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 will render this ruling void.

   Except as specifically ruled above, we express no opinion concerning the federal

tax consequences of the transactions described above under any other provisions of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation or Trust’s eligibility to be a QSST.

  This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

   Pursuant to a power of attorney on file, we are sending a copy of this letter to X’s

authorized representative.
PLR-138913-13 6

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the rulings requested, it is subject to verification on
examination.

                                 Sincerely,

                                 /s/

                                 Mary Beth Carchia
                                 Senior Technician Reviewer, Branch 3
                                 Office of the Associate Chief Counsel
                                 (Passthroughs & Special Industries)

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