Second-class-of-stock terms received inadvertent relief

Plain-English summary

An S corporation’s governing documents allowed disproportionate shareholder distributions, potentially creating a prohibited second class of stock, and its Form 2553 also listed an incorrect effective date. The corporation represented that every actual distribution had been proportional to ownership and that all returns had consistently treated it as an S corporation. It later amended the governing documents to remove the problematic provisions and agreed with its shareholders to make any required adjustments. The IRS found the possible ineffectiveness inadvertent under section 1362(f) and treated the corporation as an S corporation from its formation date, assuming the election was not otherwise terminated.

Ruling snapshot

• Question: Could the corporation receive inadvertent-election relief for governing terms that allowed disproportionate distributions?
• Outcome: Approved
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d)(2), 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201524006 Third Party Communication: None
Release Date: 6/12/2015 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
--------------, ID No. ----------------
------------------------------------ Telephone Number:
------------------------------- --------------------
------------------------- Refer Reply To:
----------------------------------- CC:PSI:B01
PLR-133231-14
Date:
March 04, 2015

LEGEND

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

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

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

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

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

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

This responds to a letter dated August 28, 2014, submitted on behalf of X, by X’s
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code (the Code).

FACTS

According to the information submitted and representations made within, X was was
formed on Date 1 and made an S election effective Date 2, under the laws of State.

X’s S corporation election was potentially ineffective because X’s governing documents
allowed for disproportionate distributions to shareholders, possibly creating a second
class of stock. X also listed an incorrect effective date, Date 2, on the Form 2553. On

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Date 3, X and its shareholders amended its governing documents to remove the
provisions allowing for disproportionate distributions.

X represents that the potential invalidity of its S election was inadvertent and was not
motivated by tax avoidance or retroactive tax planning. X represents that all of X’s
distributions to shareholders have been pro rata in accordance with their ownership
interests. X also represents that X and its shareholders agree to make any adjustments
required as a condition of obtaining relief under the inadvertent invalid election rule as
provided under § 1362(f) of the Code that may be required by the Secretary. X and its
shareholders represent that they have filed all returns consistently with X being an S
corporation.

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 the 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 1 class of stock.

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(f) provides, in part, that if (1) an election under § 1362(a) by any
corporation was not effective for the taxable year for which made by reason of a failure
to meet the requirements of § 1361(b), (2) the Secretary determines that the
circumstances resulting in the ineffectiveness were inadvertent, (3) no later than a
reasonable period of time after the discovery of the circumstances resulting in the
ineffectiveness, steps were taken so that the corporation for which the election was
made is a small business corporation, and (4) the corporation for which the election was
made, and each person who was a shareholder in such corporation at any time during
the period specified by § 1362(f), agrees to makes 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, the corporation is treated as an S corporation during the period
specified by the Secretary.

CONCLUSION

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Based solely on the facts submitted and the representations made, we conclude X’s S
election may have been ineffective. We further conclude that the potential
ineffectiveness of X’s S corporation election was inadvertent within the meaning of
§ 1362(f). Therefore, X will be treated as an S corporation effective Date 1 and
thereafter, provided X’s S corporation election is not otherwise terminated under
§ 1362(d).

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to your authorized representative.

                                  Sincerely,


                                  Joy C. Spies
                                  Joy C. Spies
                                  Senior Technician Reviewer, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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

cc: