Disproportionate distributions do not end S status after relief

Plain-English summary

An S corporation made disproportionate distributions to its shareholders over multiple years, then made corrective distributions to several shareholders. Its articles provided for one class of stock with equal economic rights, and neither the corporation nor its shareholders intended to terminate the S election. The IRS ruled that, if the unequal distributions caused a termination, the termination was inadvertent under section 1362(f). The corporation would therefore be treated as an S corporation continuously from its election date, provided its status was not otherwise terminated. Both the disproportionate and corrective distributions must receive their proper tax treatment.

Ruling snapshot

• Question: If disproportionate shareholder distributions terminated the corporation's S election, may the termination be treated as inadvertent?
• Outcome: Approved.
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d), 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: 201518008 Third Party Communication: None
Release Date: 5/1/2015 Date of Communication: Not Applicable
Index Number: 1361.01-04
Person To Contact:
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---------------------- Refer Reply To:
CC:PSI:B01
PLR-126808-14
Date:
December 29, 2014

LEGEND:

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

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

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

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

Year 1 = ------
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Year 2 = -

A = ------------------------------------------------------------------------------------------------------------
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B = ------------------------------------------------------------------------------------------------------------
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C = ------------------------------------------------------------------------------------------------------------
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D = ------------------------------------------------------------------------------------------------------------
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E =

Dear------------------
PLR-126808-14 2

This responds to a letter dated June 25, 2014, submitted on behalf of X by its
authorized representatives, requesting relief under § 1362(f) of the Internal Revenue
Code (the Code).

Facts

The information submitted states that X was incorporated on Date 1 in State and
elected to be treated as an S corporation effective Date 2. From Year 1 to Year 2, X
made disproportionate distributions to its shareholders, A, B, C, D and E. X’s Articles of
Incorporation provide that there shall only be one class of X stock, each share of which
shall have equal powers, preferences, and rights. In Year 2, X made corrective
distributions to A, C, D, and E in an effort to eliminate the cumulative amount of the
disproportionate distributions.

X represents that neither X nor its shareholders intended to terminate X’s Subchapter S
election. In addition, X represents that X and its shareholders agree to make any
adjustments required as a condition of obtaining relief under the inadvertent termination
rule as provided under § 1362(f) that may be required by the Secretary.

Law and Analysis

Section 1361(a)(1) provides that the term “S corporation” means, with respect to the
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 the term “small business
corporation “ means a domestic corporation that, among other things, does not have
more than one class of stock. Accordingly, S corporations may not have more than one
class of stock.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides 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 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
PLR-126808-14 3

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)(A) provides that an election under § 1362(a) shall be terminated
whenever (at any time on or after the 1st day of the taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation. Section 1362(d)(2)(B) further 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 was
terminated under § 1362(d)(2) or (3); (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 the
termination, steps were taken so that the corporation is a small business corporation;
and (4) the corporation, and each person who was a shareholder of the corporation at
any time during the period specified under § 1362(f), agrees to make the adjustments
(consistent with the treatment of the corporation as an S corporation) as may be
required by the Secretary for that period, then, notwithstanding the circumstances
resulting in such termination, the corporation shall be treated as an S corporation during
the period specified by the Secretary.

Conclusion

Based solely on the facts submitted and the representations made, we conclude that if
the disproportionate distributions that X made to its shareholders in Year 1 through Year
2 caused X’s S corporation election to terminate, the termination was inadvertent within
the meaning of § 1362(f). Therefore, X will be treated as an S corporation effective
Date 2 and thereafter, provided X’s S corporation election is not otherwise terminated
under § 1362(d). However, disproportionate and corrective distributions must be given
appropriate tax effect.

Except as specifically set forth above, we express or imply no opinion as to the federal
tax consequences of the above facts under any other provision of the Code.
Specifically, we express or imply no opinion concerning whether X’s S corporation
election is valid under § 1362.

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.
PLR-126808-14 4

In accordance with the power of attorney on file with this office, a copy of this letter is
being sent to X’s authorized representative.

                                    Sincerely,


                                    Joy C. Spies
                                    Joy C. Spies
                                    Senior Technician Reviewer, Branch 1
                                    (Passthroughs & Special Industries)

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

cc: