Second stock class defect does not invalidate S status

Plain-English summary

A corporation's original operating agreement created a second class of stock, making its S corporation election invalid. After discovering the problem, the corporation adopted a new agreement that removed the offending provisions. It represented that the defect was inadvertent, was not motivated by tax avoidance or retroactive planning, and that all returns had treated it as an S corporation. The IRS granted inadvertent-election relief and treated the corporation as an S corporation from its original effective date, provided the election was not otherwise terminated.

Ruling snapshot

• Question: Can the corporation retain S status after its operating agreement inadvertently created a second class of stock?
• Outcome: Approved, the invalid election was inadvertent and the corporation is treated as an S corporation from the original effective date
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201603016 Third Party Communication: None
Release Date: 1/15/2016 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
----------------------------------------------- ----------------, ID No. ------------------
--------------------------------- Telephone Number:
------------------------ ----------------------
----------------------------- Refer Reply To:
CC:PSI:BO1
PLR-114036-15
Date:
October 01, 2015

LEGEND

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

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

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

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

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

This responds to a letter dated April 13, 2015, and supplemental correspondence,
submitted on behalf of X, by X’s authorized representative, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code) for an inadvertent invalid S
election.

FACTS

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

X represents that its original operating agreement created a second class of stock
causing its S election to be invalid. X represents that on Date 2 it discovered that its S
election was invalid. X took corrective action by adopting a new operating agreement
eliminating the provisions that caused X to have a second class of stock.

X represents that its invalid S election was inadvertent and was not motivated by tax
avoidance or retroactive tax planning. X also represents that X and its shareholders
PLR-114036-15 2

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 X with 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 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.
PLR-114036-15 3

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
the invalidity 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,


                                  David R. Haglund
                                  David R. Haglund
                                  Branch Chief, 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