Disproportionate distributions did not end S status

Plain-English summary

An S corporation made disproportionate distributions to shareholder grantor trusts over several years, then made a corrective distribution that restored cumulative proportionality. The corporation represented that it never intended to create different rights among its shares. The IRS focused on the governing provisions, which gave every share identical rights to distributions and liquidation proceeds. It ruled that the uneven payments did not create a second class of stock and therefore did not terminate the S election. The disproportionate and corrective distributions still must receive the tax treatment required by their facts and timing. The IRS did not rule on the validity of any IRC § 338(h)(10) election.

Ruling snapshot

• Question: Did disproportionate shareholder distributions create a second class of stock and terminate the corporation's S election?
• Outcome: Approved
• Key authorities: IRC §§ 1361 and 1362(d)(2); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201444021 Third Party Communication: None
Release Date: 10/31/2014 Date of Communication: Not Applicable
Index Number: 1361.01-04
Person To Contact:
------------------------------------------------------------ ---------------------, ID No. ----------------
-------------------------- Telephone Number:
-------------------- --------------------
---------------------------- Refer Reply To:
------------------------------ CC:PSI:B02
PLR-117357-14
Date:
May 21, 2014

                                                 Legend

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

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

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

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

Year 1 = ------

Year 2 = ------

Year 3 = ------

A = ---------------------
SSN: ----------------

B = ---------------------
SSN: ----------------

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

   This responds to a letter dated April 21, 2014, submitted on behalf of X by its

authorized representative, requesting a ruling under subchapter S of the Internal
Revenue Code.

PLR-117357-14 2

  The information submitted states that X was incorporated in State on Date 1. X

made an election to be treated as an S corporation effective Date 2. From Year 1 to
Year 2, X made disproportionate distributions to its shareholders, grantor trusts owned
by A and B. X represents that it did not intend to create any differences in rights among
the shares. In Year 3, X made corrective distributions to A eliminating the cumulative
amount of the disproportionate distributions. As a result of the corrective distribution,
the cumulative distributions from X to its shareholders are proportionate to stock
ownership.

  X represents that it did not intend to create a second class of stock. X and its

shareholders consent to make such adjustments consistent with the treatment of X as
an S corporation as may be required by the Secretary.

   Section 1361(a)(1) of the Code 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)(B) provides that the term “small business corporation” means

a domestic corporation which is not an ineligible corporation and which does not 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.

   Section 1.1361-1(l)(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.
Differences in voting rights among shares of stock of the corporation are disregarded for
purposes of determining whether a corporation has more than one class of stock.

    Section 1.1361-1(l)(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.

   Section 1362(d)(2) provides that (A) in general, an election under § 1362(a) shall

be terminated whenever (at any time on or after the first day of the first taxable year for
which the corporation is an S corporation) such corporation ceases to be a small

PLR-117357-14 3

business corporation and (B) any termination under § 1362(d)(2) shall be effective on
and after the date of cessation.

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

that because X’s stock has identical distribution and liquidation rights under its
governing provisions, the disproportionate distributions did not cause X to have more
than one class of stock for purposes of § 1361(b)(1)(D). Under these circumstances,
we conclude that X’s S corporation election did not terminate. However,
disproportionate and corrective distributions must be given appropriate tax effect.

   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. In particular, we express no opinion regarding the validity of any § 338(h)(10)
election. See Treas. Reg. § 1.338(h)(10)-1(c)(3).

    In accordance with the Power of Attorney on file with this office, a copy of this

letter ruling will be sent to the taxpayer’s representatives.

  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.

                                    Sincerely,



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

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