IRS grants inadvertent-relief for an invalid S corporation election

Plain-English summary

An entity's S corporation election may have been ineffective because it had an ineligible shareholder and a possible second class of stock. The entity transferred the shares to an eligible shareholder, converted to a limited liability company, and amended loans so they would qualify as straight debt under IRC § 1361(c)(5). It represented that the problem was inadvertent, not tax-motivated, and that all returns had treated it consistently as an S corporation. The entity and its shareholders also agreed to make any adjustments required by the IRS. The IRS granted relief under IRC § 1362(f) and treated the entity as an S corporation from the original election date forward, provided the election was not otherwise terminated.

Ruling snapshot

• Question: May an ineffective S election caused by an ineligible shareholder and possible second class of stock receive inadvertent-invalid-election relief?
• Outcome: Approved
• Key authorities: IRC §§ 1361(c)(5), 1362(f), and 368(a)(1)(F); Treas. Reg. § 1.1361-1

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201620007                                              Third Party Communication: None
Release Date: 5/13/2016                                        Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                               Person To Contact:
-----------------------------------                            --------------, ID No. ----------------
--------------------------------------                         Telephone Number:
----------------------------------------------------------     --------------------
---------------------------------------------------            Refer Reply To:
-----------------------------                                  CC:PSI:B01
                                                               PLR-135669-15
                                                               Date:
                                                               February 01, 2016




LEGEND

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

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

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

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

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

State                      =        --------



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

This responds to a letter signed October 28, 2015, 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 a
limited partnership organized under the laws of State on Date 1. X elected to be treated
as an association taxable as a corporation and made an election to be treated as an S
corporation under the laws of State effective Date 2.
PLR-135669-15                                    2


X’s S election on Date 2 may have been ineffective due to an ineligible shareholder and
a second class of stock. X represents that it took the following corrective actions: (1) on
Date 3 the X shares were transferred from the ineligible shareholder to an eligible
shareholder; and (2) on Date 4 converting to a limited liability company under the laws
of State, and by making conforming amendments to certain loans so that they qualify as
straight debt under § 1361(c)(5). X represents that the conversion on Date 4 qualified
as an F reorganization within the meaning of § 368(a)(1)(F). X represents that other
than the possible ineffectiveness of its S corporation election, X has continuously
qualified as an S corporation since Date 2.

X represents that the possible ineffectiveness of its S election was inadvertent and was
not motivated by tax avoidance or retroactive tax planning. X also represents that X
and its shareholders 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 consistent with X 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 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 § 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 1361(c)(5)(A) provides, in general, that for purposes of § 1361(b)(1)(D), straight
debt shall not be treated as a second class of stock.

Section 1361(c)(5)(B) provides that for purposes of § 1361(c)(5), the term “straight debt”
means any written unconditional promise to pay on demand or on a specified date a
sum certain in money if (i) the interest rate (and interest payment dates) are not
contingent on profits, the borrower’s discretion, or similar factors, (ii) there is no
convertibility (directly or indirectly) into stock, and (iii) the creditor is an individual (other
than a nonresident alien), an estate, a trust described in § 1361(c)(2), or a person which
is actively and regularly engaged in the business of lending money.

Section 1361(c)(5)(C) provides that the Secretary shall prescribe such regulations as
may be necessary or appropriate to provide for the proper treatment of straight debt
under Subchapter S and for the coordination of such treatment with other provisions of
this title.
PLR-135669-15                                3


Treas. Reg. § 1.1361-1(I)(1) 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.

Section § 1.1361-1(I)(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, bylaws, applicable state laws,
and binding agreements relating to distribution and liquidation proceeds (collectively,
governing provisions).

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.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election may have been ineffective. We further conclude that, if the
election was ineffective, the ineffectiveness was inadvertent within the meaning of
§ 1362(f). Therefore, X will be treated as an S corporation effective Date 2 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.
PLR-135669-15                                4

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to your authorized representative.

                                      Sincerely,


                                      Laura C. Fields
                                      Laura C. Fields
                                      Senior Technician Reviewer
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)



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



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