Preferred units receive inadvertent S termination relief

Plain-English summary

An LLC taxed as an S corporation amended its operating agreement to give Class A units a preferential distribution right while Class B units shared only after that preference. Because the governing provisions gave the classes different distribution rights, issuing Class B units created a prohibited second class of stock and terminated the S election. The company later amended the agreement so both classes had identical distribution rights and made corrective distributions to eliminate the preference’s effect. The IRS found that the termination was inadvertent and not motivated by tax avoidance or retroactive planning. It allowed the company to continue as an S corporation, provided the company and all affected shareholders report income, basis, and distributions consistently with uninterrupted S status.

Ruling snapshot

• Question: Could the company retain S status after issuing units with different distribution rights?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201545012 Third Party Communication: None
Release Date: 11/6/2015 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------ ---------------------, ID No. ------------------
----------------------------------------- Telephone Number:
----------------------------------------------------- ----------------------
------------------------------- Refer Reply To:
CC:PSI:B01
PLR-106494-15
Date:
July 28, 2015

                                                    Legend

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

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

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

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

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

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

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

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

$N1 = ----------

Class A = ------------------------------------------------------------------------------------------
--------------------

Class B = ------------------------------------------------------------------------------------------

Dear ---------------:
PLR-106494-15 2

   This letter responds to a letter dated January 29, 2015, and subsequent

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

                                       Facts

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

company prior to Date 1, and made an election to be treated as an S corporation
effective Date 1.

    X's operating agreement was amended and restated as of Date 2, to authorize

the issuance of new classes of membership interests in X. The shares held by the
original members were classified as Class A units. The amended operating agreement
provided that a holder of the Class A units would each receive a $N1 preferential
distribution right over the Class B unit holders, and would hold the sole voting rights.
Class B unit holders would share in the distributions after the preferential distributions
on a pro rata basis with the Class A unit holders.

  At the time that the operating agreement was amended, the original members

exchanged their ownership interests for Class A units. Beginning on Date 3 through
Date 4, X issued interests in the Class B units to various persons.

    In Date 5, X amended its operating agreement to eliminate the Class A preferred

distribution rights and to provide that the Class B unit holders have distribution rights
that are identical to the distribution rights that the Class A unit holders have. On Date 6,
X made corrective distributions to eliminate the effect of the Class A preferred
distribution rights.

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

distribution rights to 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.

                                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,
PLR-106494-15 3

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(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
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
PLR-106494-15 4

in such termination, such corporation shall be treated as an S corporation during the
period specified by the Secretary.

                                    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. We further conclude that the termination constituted an
inadvertent termination within the meaning of § 1362(f).

   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 has not otherwise been terminated
under §1362(d). Accordingly, from Date 3 and thereafter, the shareholders of X,
including any Class B unit holders that were shareholders during the relevant year, must
include their pro rata share of the separately stated and non-separately stated
computed items of X as provided in §1366, make any adjustments to basis as provided
in §1367, and take into account any distributions made by X as provided in §1368. If X
and its shareholders fail to treat X as described above, this ruling will be null and void.

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

the federal tax consequences of the facts described above 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) of

the Code provides that it may not be used or cited as precedent.

    In accordance with a power of attorney on file with this office, we will send a copy

of this letter ruling to X's authorized representative.

                                   Sincerely,

                                   David R. Haglund
                                   David R. Haglund
                                   Chief, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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