Corrected disproportionate distributions do not terminate S election

Plain-English summary

An S corporation paid state composite and withholding taxes for certain nonresident shareholders but mistakenly reduced all shareholders' cash tax distributions ratably. That error produced disproportionate aggregate distributions because only some shareholders received the benefit of the state-tax payments. The corporation later made equalizing cash distributions and adopted procedures to prevent recurrence. The IRS ruled that the disproportionate and corrective payments did not create a second class of stock because the governing provisions gave every share identical distribution and liquidation rights. The S corporation election therefore did not terminate, although the payments still had to receive their proper tax treatment.

Ruling snapshot

• Question: Did mistaken state-tax adjustments and later equalizing distributions create a second class of stock and terminate the S election?
• Outcome: No, because all shares retained identical rights under the governing provisions.
• 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: 201608007                             Third Party Communication: None
Release Date: 2/19/2016                       Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-00,
              1361.01-04, 1362.00-00,         Person To Contact:
              1362.01-00                      ------------------------, ID No. ------------------
                                              ---------------------------------------------------
------------------------                      Telephone Number:
-------------------------------               ---------------------
---------------------                         Refer Reply To:
--------------------------------              CC:PSI:B03
                                              PLR-126072-15
                                              Date:
                                              October 29, 2015




LEGEND

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

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

Date1 =           ----------------------

Date2 =           ---------------------

Date3 =           -------------

Date4 =           -----------------

Date5 =           ------------------

Date6 =           ------------------

Date7 =           ------------------


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

      This responds to a letter dated July 30, 2015, and subsequent correspondence,
submitted on behalf of X by X’s authorized representative, requesting a ruling under
§1361 of the Internal Revenue Code (“Code”).


PLR-126072-15                                 2

        The information submitted states that X was incorporated under the laws of State
on Date1. X elected to be an S corporation effective Date2. Pursuant to the laws of
State, all shareholders have equal rights to distributions and liquidation proceeds,
unless modified by the articles of incorporation. X has represented that neither X’s
articles of incorporation and bylaws nor any other binding agreements modify these
rights.

        According to the submission, X has filed various state income tax returns,
including State, and paid the required shareholder level composite state income tax or
the state income tax withholdings due on those returns since Date3. On a state-by-
state basis, these state income tax payments are made by X on behalf of each of X’s
shareholders who are not residents of the state to which composite state income tax or
state income tax withholdings are paid. X’s shareholders for whom these income taxes
are paid (the “Applicable Shareholders”), varies each year depending on the state
involved, the state of residency of each shareholder, and the level of taxable income
attributed to each shareholder. X declares and pays cash distributions to its
shareholders on an annual basis, and these distributions fall into two separate
categories. One category is referred as “personal distributions,” and the other category
is referred to as “tax distributions.” Both categories of distributions are declared and
paid on a ratable per share basis. When X calculates the total tax distribution payable
annually to its shareholders, X reduces the Applicable Shareholders’ tax distribution
checks by the amount of state composite and withholding taxes paid by X and credited
to the Applicable Shareholders. This is performed specific to each shareholder, based
on the shareholder’s specific composite tax allocations.

       On Date4, X discovered that for tax years ending Date5 through Date6, X
inadvertently reduced all of its shareholders’ tax distributions ratably by the total amount
of state composite and withholding taxes paid on behalf of the Applicable Shareholders.
X’s federal income tax returns, and related Schedules K-1, reported the state composite
and withholding taxes as distributed ratably to each shareholder, rather than distributed
specifically to the Applicable Shareholders who benefit from the state composite and
withholding taxes paid by X. As a result, the Applicable Shareholders received
disproportionate distributions, to the extent state composite and withholding taxes were
credited (thereby reducing total cash distributions) to the other shareholders.

         On Date7, X made equalizing cash distributions to correct the discrepancies
between and among the shareholders resulting from the erroneous tax distributions.
After these corrective cash distributions, each shareholder has now received, in
aggregate, distributions proportionate to the shareholders’ ownership percentages in X,
for all years. X represents that it has also implemented policies and procedures to
ensure that future state composite and withholding taxes paid by X for the benefit of the
Applicable Shareholders will be equalized annually with reciprocal cash distributions to
the other shareholders.


PLR-126072-15                                  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 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 which does not have, among other things, more than one class of
stock.

       Section 1.1361-1(l)(1) of the Income Tax Regulations 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 stock
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). 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.

       Based solely on the facts submitted and the representations made, we conclude
that, because X’s stock has identical distribution and liquidation rights under its
governing provisions, X’s disproportionate distributions to some of the shareholders and
X’s corrective distributions to certain shareholders do not cause X to have more than
one class of stock for purposes of § 1361(b)(1)(D). However, such disproportionate and
corrective distributions must be given appropriate tax effect. Under these
circumstances, we conclude that X’s S corporation election did not terminate because of
the disproportionate and corrective distributions to the shareholders.

       Except as specifically set forth above, we express or imply no opinion concerning
the federal income tax consequences of the facts of this case described above under
any other provision of the Code and the regulations thereunder. Specifically, we
express or imply no opinion regarding whether X otherwise qualifies as a small business
corporation under § 1361.


PLR-126072-15                                4

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

      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 the Power of Attorney on file with this office, we are sending
copies of this letter to your authorized representatives.


                                      Sincerely,


                                      Bradford R. Poston
                                      Senior Counsel, Branch 3
                                      Office of Associate Chief Counsel
                                      (Passthroughs & Special Industries)

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

cc: