Convertible debenture receives inadvertent S election relief

Plain-English summary

An S corporation issued a convertible debenture that may have created a prohibited second class of stock and terminated its S election. The corporation later retired the debenture and ended the purchase agreement. It represented that the possible termination was inadvertent, was not motivated by tax avoidance, and that its returns consistently treated it as an S corporation. The IRS ruled that any ineffective election or termination caused by the debenture was inadvertent under § 1362(f). The corporation could continue as an S corporation, provided its election was otherwise valid and shareholders reported items, basis adjustments, and distributions consistently with S corporation treatment.

Ruling snapshot

• Question: Did a convertible debenture cause a curable inadvertent termination of the corporation's S election?
• Outcome: Approved. Any ineffectiveness or termination was treated as inadvertent.
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(f), 1366, 1367, 1368

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201434016
Third Party Communication: None
Release Date: 8/22/2014
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B2
PLR-146089-13
Date:
April 29, 2014

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

D1 = -------------------------------------------------------------------------------------------------------------------------
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D2 = -------------------------------------------------------------------------------------------------------------------------
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D3 = -------------------------------------------------------------------------------------------------------------------------
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D4 =

Dear ------------------

This responds to a letter dated November 6, 2013, and subsequent correspondence, submitted on behalf of X by X’s authorized representative, requesting relief under § 1362(f) of the Internal Revenue Code.

The information submitted states that X was incorporated under the laws of State on D1 and made an S election effective D2. X’s issuance of a convertible debenture to A pursuant to a “Convertible Debenture Purchase Agreement” on D3 may have inadvertently created a second class of stock in violation of the one class of stock requirement under § 1361(b)(1)(D). Therefore, X’s S corporation election may have terminated on D3. On D4, X retired the convertible debenture.

X represents that the circumstances resulting in X’s possible invalid S corporation election were inadvertent and not motivated by tax avoidance or retroactive
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tax planning. Further, the convertible debenture was returned and the Purchase Agreement was terminated on or before D4. X further represents that X has filed returns consistent with X’s status as an S corporation since D2. X and its shareholders have agreed to make such adjustments (consistent with the treatment of X as an S corporation) as may be required by the Secretary.

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 it was 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 event resulting in the 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 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 such ineffectiveness or termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Based solely on the facts submitted and the representations made, we conclude that X may have terminated its S election on D3 because of the creation of a second class of stock. We also conclude that any ineffective election on D3 or termination of X’s S election on D3 was inadvertent within the meaning of § 1362(f). Therefore, we conclude that X will be treated as an S corporation from D3 and thereafter, provided that X’s S corporation election was otherwise valid and was not otherwise terminated under § 1362(d).

This ruling is conditioned upon the shareholders of X including in income their pro rata share of the separately stated and nonseparately computed items of X as provided in § 1366, making any adjustments to basis as provided in § 1367, and taking into account any distributions made by X as provided by § 1368.

Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the facts described above under any other provision of the Code. Specifically, no opinion is expressed regarding X’s eligibility to be an S corporation.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.
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Pursuant to a power of attorney on file with this office, a copy of this letter is being sent to X’s authorized representatives.

Sincerely,

Melissa Liquerman
Branch Chief, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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

cc: