Corrected unequal distributions preserve S corporation status

Plain-English summary

An S corporation made disproportionate shareholder distributions during three tax years, potentially creating a prohibited second class of stock. Its governing documents nevertheless gave every share identical distribution and liquidation rights, and the company corrected the cumulative imbalance after discovering the error. The IRS ruled that any resulting termination was inadvertent and that the corrective distributions did not themselves create a second class of stock. The corporation would continue to be treated as an S corporation, assuming its election was valid and had not otherwise terminated.

Ruling snapshot

• Question: Did disproportionate distributions terminate the corporation's S election by creating a second class of stock?
• Outcome: Approved
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d)(2), 1362(f); Treas. Reg. §§ 1.1361-1(l), 1.1362-4(d)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201538009 Third Party Communication: None
Release Date: 9/18/2015 Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.01-04
Person To Contact:
------------------------------------------- ---------------------------, ID No. ---------------
--------------------------------- -----------------------------------------------------
--------------------------- Telephone Number:
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Refer Reply To:
CC:PSI:01
PLR-144393-14
Date:
May 19, 2015

Legend
X = ---------------------------------------------------------------------------------------
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State = ------------
Date 1 = ---------------------
Date 2 = ---------------------
Trust A = ---------------------------------------------------------------------------------------
------------------------------------
Trust B = ---------------------------------------------------------------------------------------
-----------------------------------
Individual = ---------------------------------------------------------------------------------------
------------------------------------
Year 1 = ------
Year 2 = ------
Year 3 = ------

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

This responds to a letter dated November 25, 2014, and subsequent correspondence,
submitted on behalf of X by its authorized representatives, requesting a ruling relating to
X’s status as an S corporation under §§ 1361 and 1362 of the Internal Revenue Code.

                                                  Facts

The information submitted states that X was incorporated under the laws of State on
Date 1. X elected to be treated as an S corporation for Federal tax purposes effective
Date 2. At the time of the S election, all of the shares of X stock were held by Trust A,
Trust B, and Individual.

PLR-144393-14 2

X made disproportionate distributions to its shareholders in taxable years Year 1, Year
2, and Year 3, which may have created a second class of stock in violation of the one
class of stock requirement under § 1361(b)(1)(D). After the discovery of the errors, X
took remedial action and made corrective distributions to the shareholders, thus
eliminating the cumulative amount of the disproportionate distributions.

X represents that under its governing provisions, all of X’s shares of stock possess
identical rights to distribution and liquidation proceeds and that no provision exists in the
governing documents, regulations, or by-laws that vary these rights and X represents
that no other binding agreement exists that varies these rights. X further represents that
neither X nor its shareholders knew that disproportionate distributions could terminate
X’s S corporation election.

X represents that the possible termination was not motivated by tax avoidance or
retroactive tax planning. X and its shareholders have agreed to make any further
adjustments the Commissioner may require consistent with the treatment of X as an S
corporation.

Law and Analysis

Section 1361(a) 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)(D) provides that, for purposes of subchapter S, the term “small
business corporation” means a domestic corporation that is not an ineligible corporation
and that does not, among other things, have more than one class of stock.

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 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, by-laws, 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
of § 1361(b)(1)(D) and § 1.1361-1(l). Although a corporation is not treated as having
more than one class of stock so long as the governing provisions provide for identical

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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 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361-1(b)(3), (4), and
(5) (relating to restricted stock, deferred compensation plans, and straight debt), in
determining whether all outstanding shares of stock confer identical rights to distribution
and liquidation proceeds, all outstanding shares of stock of a corporation are taken into
account.

Section 1362(a) provides, in part, that a small business corporation may elect to be an
S corporation. 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 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 (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 consent, 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 the ineffectiveness or termination,
steps were taken - (A) so that the corporation is a small business corporation, or (B) to
acquire the required shareholder consents, and (4) the corporation, and each person
who was a shareholder of 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
ineffectiveness or termination, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that
are appropriate. In general, the adjustments required should be consistent with the
treatment of the corporation as an S corporation during the period specified by the
Commissioner.

Conclusion

Based solely on the facts submitted and representations made, we conclude that
because X made disproportionate distributions to its shareholders, X may have had
more than one class of stock beginning in Year 1. We conclude, however, that if X’s
S election was terminated, such termination was inadvertent within the meaning of
§ 1362(f). Further, we conclude that the corrective actions taken by X and its

PLR-144393-14 4

shareholders do not create a second class of stock under § 1361. Consequently, we
rule that X will be treated as an S corporation for Year 1, and thereafter, provided X’s S
corporation election was valid and was not otherwise terminated under § 1362(d).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. 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. Pursuant to a
power of attorney on file, a copy of this letter is being sent to X’s authorized
representatives.

                                  Sincerely,


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

Enclosures (2)
Copy of Letter
Copy for 6110 purposes

cc: