Repaid disproportionate distributions do not terminate S election

Plain-English summary

An S corporation made disproportionate distributions to certain shareholders to cover their anticipated taxes on pass-through income. Its governing documents and state law provided identical distribution and liquidation rights for every share, and the recipients later repaid the excess distributions in full. The IRS ruled that the payments did not create a second class of stock. The corporation's S election therefore did not terminate, assuming the election was valid and had not ended for another reason.

Ruling snapshot

• Question: Did disproportionate tax distributions create a second class of stock and terminate the corporation's S election?
• Outcome: No, because the governing provisions gave all shares identical rights and the excess payments were repaid.
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201608006                                            Third Party Communication: None
Release Date: 2/19/2016                                      Date of Communication: Not Applicable
Index Number: 1361.01-04
                                                             Person To Contact:
-----------------------------------------                    ---------------------------, ID No. ---------------
--------------------------------------                       ----------------
-------------------------------                              Telephone Number:
-------------                                                ---------------------
---------------------------------                            Refer Reply To:
                                                             CC:PSI:B3
                                                             PLR-125266-15
                                                             Date:
                                                             November 09, 2015


Legend

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

State             = ---------

D1                = -------------------------

D2                = -------------------------

Years             = ---------------------------------------------------------


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

This responds to a letter dated July 20, 2015 submitted on behalf of X by its authorized
representative, 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 D1
and made an election to be treated as an S corporation effective D2. During Years, X
made disproportionate distributions to certain shareholders during the course of its
operations. These distributions were made in order to cover the distributees’
anticipated federal income tax liability on their pro rata share of S corporation pass-
through income.

X represents that each share of X has identical rights to liquidation proceeds and
distributions. No provision exists in the governing documents, regulations, or by-laws


PLR-125266-15                                 2

that vary these rights. X represents that the laws of State do not permit disproportionate
distributions. X also represents that no other binding agreement exists that vary these
rights. In addition, X represents that the recipient shareholders have repaid the
disproportionate distributions in full to X. Finally, X represents that it always intended to
be an S corporation since D2.

X represents that at all relevant times, X and its shareholders treated X as an S
corporation and filed their tax returns accordingly.

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 § 1.1362(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,
a trust described in § 1361(c)(2), or an organization described in § 1362(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) of the Income Tax Regulations provides 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. Thus, if all shares of stock of an S
corporation have identical rights to distribution and liquidation proceeds, the corporation
may have voting and nonvoting common stock, a class of stock that may vote only on
certain issues, irrevocable proxy agreements, or groups of shares that differ with
respect to rights to elect members of the board of directors.

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


PLR-125266-15                                 3

more than once 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 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361(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.

Conclusion

Based solely on the facts submitted and representations made, we conclude that the
disproportionate distributions X made certain shareholders did not create a second
class of stock for purposes of § 1361(b)(1)(D). Thus, we conclude that X’s S
corporation election did not terminate under § 1.1362(d)(2)(A) and that X will be treated
as an S corporation beginning on D2 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
representative.
                                         Sincerely,


                                      Bradford R. Poston
                                      Senior Counsel, Branch 3
                                      (Passthroughs & Special Industries)

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

cc: