Partnership-style operating agreement receives inadvertent S election relief

Plain-English summary

A limited liability company adopted an operating agreement containing partnership-style capital-account, allocation, and liquidation provisions before later electing S corporation status. Because those provisions could give the two owners different rights to liquidation proceeds, the company may have had more than one class of stock and its S election may have been ineffective. Once advised of the issue, the company and owners amended the agreement so profits, losses, and distributions would follow their S corporation ownership shares. They represented that all prior tax items and distributions had in fact been handled pro rata and that they had always intended S treatment. The IRS ruled that any ineffectiveness was inadvertent under section 1362(f) and allowed S status from the original election date forward.

Ruling snapshot

• Question: Can the company retain S status when its operating agreement contained partnership provisions that might create unequal liquidation rights?
• Outcome: Approved
• Key authorities: IRC §§ 704, 1361(b)(1)(D), 1362(d), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                         Department of the Treasury
                                                                 Washington, DC 20224

Number: 201528025                                                Third Party Communication: None
Release Date: 7/10/2015                                          Date of Communication: Not Applicable
Index Number: 1361.01-04, 1362.04-00
                                                                 Person To Contact:
-------------------------------------------------                --------------------, ID No. ----------------
----------------------                                           Telephone Number:
---------------------------                                      --------------------
 ---------------------------                                     Refer Reply To:
                                                                 CC:PSI:B03
                                                                 PLR-138483-14
                                                                 Date:
                                                                 April 09, 2015


                                                    LEGEND

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

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

A                       =           --------------------------------------------------------------------------------
                                    ---------------------------------------------

B                       =           --------------------------------------------------------------------------------
                                    -------------------------------------------

Agreement 1             =           -----------------------------------------

Agreement 2             =           -------------------------------------------------

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

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

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

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

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


Dear ----------:
PLR-138483-14                                2

      This letter responds to a letter dated September 23, 2014, submitted on behalf of
X by X’s authorized representative, requesting relief under § 1362(f) of the Internal
Revenue Code (the Code).
                                          FACTS

       X was organized on Date 1 as a limited liability company under the laws of State.
Effective Date 2, X elected to be treated as a corporation. On Date 3, A and B, the
members of X, signed a new operating agreement, Agreement 1, that included
provisions in contemplation of X being treated as a partnership; however, the
applicability of those provisions was not limited to such treatment. Effective Date 4, X
elected to be treated as an S corporation. The provisions in Agreement 1 thus applied
during the period of time when X intended to be treated as an S corporation until Date 5,
as explained herein.

      Section 4 of Agreement 1 provided for the maintenance of capital accounts in
accordance with regulations under § 704 of the Code.

       Section 5 of Agreement 1 allowed for allocations to be made first to members
with positive capital accounts, as well as for special and curative allocations.

       Section 10 of Agreement 1 provided rules regarding how the dissolution and wind
up of the business would be handled. Section 10.2(c) provided that distributions would
be made to members with positive capital accounts, to the extent of their respective
capital accounts. Section 10.2(d) provided that distributions to members would be
based on their distributive shares, except that a distribution to a member with a negative
capital account would be reduced.

        After A and B were informed that, based on the provisions in Agreement 1, they
might not have identical rights to liquidation proceeds, X, A, and B entered into
Agreement 2 on Date 5 to remove or amend those provisions. Agreement 2 instead
provides for allocations of profits and losses in accordance with the shareholders’
distributive shares (their interests in the S corporation). Agreement 2 also provides that
all distributions will be proportionate to their distributive shares.

         X represents that X and its shareholders intended for X to be an S corporation
effective Date 4 and X has filed all returns consistent with X’s status as an S corporation
since Date 4. X further represents that all items of income (including tax-exempt
income), loss, deduction, or credit (the separate treatment of which could affect the
liability for tax of any shareholder) and all distributions have been pro rata based on
ownership percentage as required under the S corporation rules. Lastly, 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) of the Code.

                                  LAW AND ANALYSIS
PLR-138483-14                                 3

        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 which does not (A) have more than
100 shareholders, (B) have as a shareholder a person (other than an estate, and 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 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, in relevant part, that if (1) an election under § 1362(a)
by any corporation (A) was not effective for the taxable year for which 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 circumstances resulting in such ineffectiveness or
termination, steps were taken (A) so that the corporation for which the election was
made or the termination occurred is a small business corporation, or (B) to acquire the
required shareholder consents; and (4) the corporation for which the election was made
or the termination occurred, and each person who was a shareholder of the corporation
at any time during the period specified pursuant to § 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 with respect to this 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.

      Section 1.1361-1(l)(1) of the Income Tax Regulations provides, in part, 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.

       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 laws, and binding agreements relating to distribution and liquidation
proceeds (collectively, governing provisions).
PLR-138483-14                                 4

                                      CONCLUSION

       Based on the facts submitted and the representations made, we conclude that
X’s S corporation election may have been ineffective because X may have had more
than one class of stock. However, we conclude that if X’s S corporation election was
ineffective, such ineffectiveness was inadvertent within the meaning of § 1362(f).
Therefore, X will be treated as an S corporation effective Date 4 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.

      The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and are accompanied by a perjury statement
executed by an appropriate party. While this office has not verified any of the material
submitted in support of this request, it is subject to verification on examination.

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

        Pursuant to a power of attorney on file with this office, we are sending copies of
this letter to your authorized representatives.


                                       Sincerely,

                                       /s/

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


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



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