S corporation gets inadvertent-termination relief for distribution agreements

Plain-English summary

An S corporation entered into shareholder agreements containing two distribution clauses that gave shareholders different distribution rights. Although those provisions created more than one class of stock and terminated the S election, the corporation made only pro rata distributions while the agreements were in effect. It later amended the agreements so that all distributions depended solely on share ownership. The IRS found the termination inadvertent and treated the corporation as continuously eligible for S corporation treatment, provided its election was otherwise valid and had not otherwise terminated. The corporation and shareholders also agreed to make any adjustments required for relief.

Ruling snapshot

• Question: Could the corporation retain continuous S status after shareholder agreements created different distribution rights?
• Outcome: Approved as an inadvertent termination.
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(f); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service                                    Department of the Treasury
                                                            Washington, DC 20224

Number: 201635002                                           Third Party Communication: None
Release Date: 8/26/2016                                     Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                            Person To Contact:
------------------------------------                        --------------------------, ID No. ----------------
-----------------                                           -----------------
--------------------------                                  Telephone Number:
------------------------------------                        --------------------
                                                            Refer Reply To:
                                                            CC:PSI:B03
                                                            PLR-138324-15
         LEGEND                                             Date:
                                                            May 20, 2016
         X=                        -------------------
         ------------------------------------------------

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

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

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

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

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

         Agreements 1 =             ------------------
         -----------------------------------------
         ----------------------------------------------

         Year 1 =                 -------

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

        This responds to a letter dated November 16, 2015, submitted on behalf of X by
its authorized representative requesting a ruling under § 1362(f) of the Internal Revenue
Code (the Code).

                                                       FACTS

PLR-138324-15                                2

      X was organized on Date 1 as a corporation under the laws of State. Effective
Date 2, X elected to be treated as an S corporation.

        Between Date 3 and Date 4, X entered into Agreements 1 with its shareholders
outlining the distributions that each shareholder would receive from X. Agreements 1
utilized two separate distribution clauses that provided for differences as to the amount
of distributions X’s shareholders would be entitled to receive.

       During the period of time Agreements 1 were in effect, however, no
disproportionate distributions were made. Instead, X made distributions on a pro-rata
basis according to each shareholder’s ownership of X.

       In Year 1, X amended Agreements 1 to remove any distribution differences and
to provide that all distributions are to be made on the basis of the number of shares of X
owned by each shareholder.

        X represents that X and its shareholders intended for X to be an S corporation
effective Date 2 and that X has filed all returns consistent with X’s status as an S
corporation since Date 2. X and its shareholders agree to make any adjustments
required as a condition of obtaining relief under the inadvertent termination rule as
provided in § 1362(f) of the Code.

                                  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, and 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 1362(d)(2)(A) provides than 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. Section 1362(d)(2)(B) further provides that the termination shall
be effective on and after the date of cessation.

      Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a)
by any corporation (A) was not effective for the taxable year for which made
(determined without regard to § 1362(b)(2)) by reason of a failure to meet the

PLR-138324-15                                 3

requirements of § 1361(b) or to obtain shareholder consents or (B) was terminated
under § 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting
in the ineffectiveness or termination were inadvertent, (3) no later than a reasonable
period of time after discovery of the circumstances resulting in the ineffectiveness or
termination, steps were taken (A) so that the corporation is a small business corporation
or (B) to acquire the shareholder consents, and (4) the corporation and each person
who was a shareholder of 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 in the
ineffectiveness or termination, the corporation will be treated as an S corporation during
the period specified by the Secretary.

      Section 1.1361-1(l)(1) of the Income Tax Regulations provides, in part, 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(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, bylaws,
applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, governing provisions).

                                      CONCLUSION

       Based on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 3 because X had more than one class of
stock. However, we conclude that such termination was inadvertent within the meaning
of § 1362(f). Therefore, X will be treated as continuing to be an S corporation from Date
3 and thereafter, provided X’s S corporation election was otherwise valid and, apart
from the inadvertent termination ruling described above, has 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 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.

      The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and is 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 this request, it is subject to verification on examination.

PLR-138324-15                                 4

      This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) of
the Code provides that this ruling may not be used or cited as precedent.

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

                                              Sincerely,

                                              Holly Porter
                                              Branch Chief, Branch 3
                                              Associate Chief Counsel
                                              (Passthroughs and Special Industries)

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