Multiple unit classes and IRA owners receive S corporation relief

Plain-English summary

An LLC taxed as an S corporation amended its operating agreement to create preferred and several common-unit classes with different distribution or liquidation rights. It then issued some preferred units to individual retirement accounts, which were ineligible S corporation shareholders. The company later redeemed or exchanged the affected units and amended its agreement so that it again had one class of stock held by eligible shareholders. The IRS found the termination inadvertent and allowed S status to continue, but imposed special treatment for IRA-held shares in gain and loss periods. Relief also required corrective distributions to specified unit holders within 120 days and amended returns for two years, with failure to comply making the ruling void.

Ruling snapshot

• Question: Could the company keep S corporation status after issuing multiple stock classes and shares to ineligible IRA owners?
• Outcome: Approved, subject to corrective distributions, shareholder treatment, and amended returns
• Key authorities: IRC §§ 408, 1361, and 1362(f); Treas. Reg. §§ 1.1361-1 and 1.1362-4; Rev. Rul. 92-73

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201505008 Third Party Communication: None
Release Date: 1/30/2015 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
----------------------------------- -----------------------, ID No. -------------------
-------------------------------------- ---------------------------------------------------
-------------------------------------------- Telephone Number:
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Refer Reply To:
CC:PSI:B3
PLR-116433-14
Date:
October 14, 2014

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

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

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

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

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

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

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

Date 6 = ----------------------------

Date 7 = ------------------

Year 1 = -------

Year 2 = -------

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

   This letter responds to a letter dated April 7, 2014, and subsequent

correspondence, written on behalf of X, requesting a ruling under § 1362(f) of the
Internal Revenue Code.

PLR-116433-14 2

                                        Facts

    The information submitted states that X was formed as a State limited liability

company pursuant to an operating agreement dated as of Date 1, and made an election
to be treated as an S corporation effective Date 2. X’s operating agreement was
amended and restated as of Date 3, to authorize the issuance of new classes of
membership interests in X: Preferred Units, Class B Common Units, and Class C
Common Units. The shares held by the original members were classified as Class A
Common Units. The amended operating agreement provided that a holder of the
Preferred Units would receive preferential distribution rights over the other members.
Class A and Class B Common Unit holders would share in the distributions, income,
and losses of X on a pro rata basis, though the Class A Common Unit holders would
also receive preferential liquidation rights. The Class C Common Units holder would
only receive a distribution upon the liquidation of X.

   Beginning on Date 3 through Date 4, X issued interests in some of the new

classes of membership, including Preferred Units to individual retirement accounts
(IRAs). On Date 5 and Date 6, X redeemed all outstanding Preferred Units. On Date 7,
X redeemed all outstanding Class C Common Units, exchanged all Class B Common
Units for Class A common Units, and amended its operating agreement to eliminate all
references to any second classes of stock. As of Date 7, X only had one class of stock
held by eligible shareholders.

    X timely filed its tax returns as an S corporation for all years. X reported all items

of income, loss, deduction, and credit on a pro rata basis for Class A and B Common
Units, and made distributions only to Class A and B Common Units. No allocations or
distributions were made to Preferred Units or Class C Common Units.

   X represents that it was not aware that issuing new classes of stock to

shareholders and issuing stock to ineligible shareholders could terminate X's S
corporation election. X represents that any termination of its S corporation election was
not motivated by tax avoidance or retroactive tax planning. X and its shareholders
agree to make any adjustments consistent with the treatment of X as an S corporation,
as might be required by the Secretary.

    X requests a ruling that termination of X’s S corporation election due to the

issuance of multiple classes of stock or having ineligible shareholders was inadvertent
within the meaning of section 1362(f). Furthermore, notwithstanding the termination of
its S corporation election, X requests that it will be treated as an S corporation from
Date 3 and thereafter.

PLR-116433-14 3

                                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 such year.

    Section 1361(b)(1) 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 § 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 1.1361-1(f) of the Income Tax Regulations provides that, except as

otherwise provided in § 1.1361-1(e) (relating to nominees), § 1.1361-1(h) (relating to
certain trusts), or § 1361(c)(6) (relating to certain exempt organizations), a corporation
in which any shareholder is a corporation, partnership, or trust does not qualify as a
small business corporation.

   Rev. Rul. 92-73, 1992-2 C.B. 224, holds that a trust that qualifies as an individual

retirement account under § 408(a) is not a permitted S corporation shareholder under
§ 1361.

   Section 1.1361-1(l)(1) 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 rights 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). 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

PLR-116433-14 4

distributions) that differ in timing or amount are to be given appropriate tax effect in
accordance with the facts and circumstances.

  Section 1362(a) provides that, except as provided in § 1362(g), a small business

corporation may elect to be an S corporation.

   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(f) provides, in part, that if (1) an election under § 1362(a) by any

corporation was terminated under § 1362(d)(2); (2) the Secretary determines that the
circumstances resulting in such termination were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
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 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 termination, such corporation shall be treated as an S corporation during the
period specified by the Secretary.

    Section 1.1362-4(d) provides, in part, that in the case of stock held by an

ineligible shareholder that causes an inadvertent termination for an S corporation under
§ 1362(f), the Commissioner may require the ineligible shareholder to be treated as a
shareholder of the S corporation during the period the ineligible shareholder actually
held stock in the corporation.

                                     Conclusion

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

X’s S corporation election terminated on Date 3 as a result of X issuing units in more
than one class of stock between Date 3 and Date 4, some of which were issued to
ineligible shareholders. We further conclude that the termination constituted an
inadvertent termination within the meaning of § 1362(f).

   X has taken corrective action so that it once again meets the requirements of a

small business corporation under § 1361(b). In addition, X and its shareholders agree
to make the adjustments discussed below. Therefore, we determine that pursuant to
the provisions of § 1362(f), X will be treated as continuing to be an S corporation from
Date 3 and thereafter, provided that X’s S corporation election was otherwise valid and,

PLR-116433-14 5

apart from the inadvertent termination ruling described above, has not otherwise
terminated under § 1362(d).

    As a condition for this ruling, for any tax periods between Date 3 and Date 7 in

which X reported a net loss, shareholders who were IRAs will be treated as the
shareholders of the shares of stock held by them at that time. For any tax periods
between Date 3 and Date 7 in which X reported a net gain, the beneficiaries of the IRAs
will be treated as the shareholders of the shares of stock held by IRAs.

    Furthermore, this ruling is contingent on X making corrective distributions so that

the shareholders of the Preferred Units, Class A Common Units, and Class B Common
Units receive distributions proportionate to their interests in X from Date 3 through Date
7, within 120 days of the date of this letter if X has not already done so. Under these
facts and circumstances, we are not requiring X to make corrective distributions to the
holder of the Class C Common Units. For taxable years ending Year 1 and Year 2, X
and the shareholders of the Preferred Units, Class A Common Units, and Class B
Common Units agree to amend their tax returns consistent with the treatment described
above. If X fails to make the corrective distributions or if X or these shareholders fail to
treat themselves as described above, this ruling shall be null and void.

   Except as specifically set forth above, we express or imply no opinion as to the

federal tax consequences of the facts described above under any other provision of the
Code. In particular, no opinion is expressed as to whether X is otherwise eligible to be
an S corporation.

    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 with this office, we will send a copy of this letter ruling to X’s authorized
representative.

PLR-116433-14 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,




                                Holly Porter
                                Chief, Branch 3
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)

Enclosures (2):

  A copy of this letter
  A copy for § 6110 purposes