Late S election and two-class-stock defect receive relief

Plain-English summary

A corporation intended its S corporation election to begin on an earlier date than the effective date accepted by the IRS. It also had two classes of stock when the election was made, which made the election ineffective, but it later cancelled one class effective before the requested start date. The corporation represented that the failures were inadvertent, were not part of tax avoidance or retroactive planning, and had not caused inconsistent federal returns or non-pro rata distributions. The IRS found reasonable cause for the late election and gave the corporation 120 days to file Form 2553 with the requested effective date. It also granted inadvertent-election relief and treated the corporation as an S corporation from that date, provided the election was otherwise valid and remained in effect.

Ruling snapshot

• Question: Could the corporation obtain relief for a late S election and an inadvertent two-class-stock defect?
• Outcome: approved, subject to filing Form 2553 within 120 days
• Key authorities: IRC §§ 1361(b), 1362(b)(5), 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: 201706014
Third Party Communication: None
Release Date: 2/10/2017
Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.01-03,
1362.04-00
Person To Contact:
--------------------------, ID No. ----------------
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Telephone Number:
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Refer Reply To:
CC:PSI:B03
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November 14, 2016

LEGEND

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

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

D1 = -------

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

D3 = ------------------

Month1 = ------

Month2 = -------

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

This letter responds to a letter dated June 22, 2016, and subsequent correspondence submitted on behalf of X, requesting rulings under §§ 1362(b)(5) and 1362(f) of the Internal Revenue Code (Code).

FACTS

According to the information submitted, X was organized as a corporation under the laws of State on D1. Subsequently, X made an election to be treated as an S
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corporation effective D2. At the time of its S corporation election, X’s tax year ended on the last day of Month1, and consequently, the Service accepted X’s S corporation election with an effective date of D3, the first day of Month2. X subsequently filed a Form 1128, Application to Adopt, Change, or Retain a Tax Year, to change its tax year to one beginning on D2. However, the effective date of its S corporation election remains D3.

In addition, at the time of its S corporation election, X had more than one class of stock. When X’s advisers later discovered that X had two classes of stock outstanding, X cancelled one class of stock, effective the day before D2.

X represents that the ineffective S corporation election was inadvertent and not the result of tax avoidance or retroactive tax planning. X further represents that no federal tax return of any person has been filed inconsistent with a valid S corporation election having been made for X effective D2. X also represents that all distributions and allocations of income to its shareholders have been made pro rata in accordance with their interests in X. X and its shareholders have agreed to make any adjustments required by the Service consistent with the treatment of X as an S corporation.

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 § 1362(a) is in effect for such 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 one class of stock.

Section 1362(b)(1) provides that an election under § 1362(a) may be made by a small business corporation for any taxable year (A) at any time during the preceding taxable year, or (B) at any time during the taxable year and on or before the 15th day of the third month of the taxable year.

Section 1362(b)(3) provides that if a small business corporation makes an election under § 1362(a) for any taxable year, and the election is made after the 15th day of the third month of the taxable year and on or before the 15th day of the third month of the following taxable year, then the election is treated as made for the following taxable year.
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Section 1362(b)(5) provides that if an election under § 1362(a) is made for any taxable year (determined without regard to § 1362(b)(3)), after the date prescribed by § 1362(b) for making the election for the taxable year or no § 1362(a) election is made for any taxable year, and the Secretary determines that there was reasonable cause for the failure to timely make the election, then the Secretary may treat the election as timely made for the taxable year (and § 1362(b)(3) shall not apply).

Section 1362(f) provides that if (1) an election under § 1362(a) or § 1361(b)(3)(B)(ii) 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 requirements of § 1361(b) or to obtain shareholder consents or (B) was terminated under § 1362(d)(2) or (3) or § 1361(b)(3)(C), (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 for which the election was made or the termination occurred is a small business corporation or a qualified subchapter S subsidiary, as the case may be, or (B) to acquire the shareholder consents, and (4) the corporation for which the election was made or the termination occurred, 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 or a qualified subchapter S subsidiary, as the case may be) 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 or a qualified subchapter S subsidiary, as the case may be, 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 laws, and binding agreements relating to distribution and liquidation proceeds (collectively, governing provisions).

CONCLUSION

Based solely on the facts submitted and representations made, we conclude that X has established reasonable cause for failing to make a timely S corporation election. Thus, we conclude that X is eligible for relief under § 1362(b)(5). Accordingly, if X makes an election to be an S corporation by filing with the appropriate service center a completed Form 2553 within 120 days following the date of this letter, containing an
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effective date of D2, the election shall be treated as timely made. A copy of this letter should be attached to the Form 2553 filed with the service center. A copy is enclosed for that purpose.

Further, we conclude that X’s S corporation election was ineffective because X had more than one class of stock. We also conclude that the circumstances resulting in any ineffectiveness of X’s S corporation election were inadvertent within the meaning of § 1362(f). Thus, under the provisions of § 1362(f), X will be treated as an S corporation effective on D2, and thereafter, provided that X’s S corporation election was otherwise valid and not otherwise terminated under § 1362(d).

Except as expressly provided herein, we express or imply no opinion concerning the federal tax consequences of the facts of this case under any other provisions of the Code. Specifically, we express or imply no opinion on whether X was otherwise eligible to be an S corporation.

This ruling is directed only to the taxpayer that requested 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, we are sending a copy of this letter to X’s authorized representative.

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 ruling request, it is subject to verification on examination.

Sincerely,

Brad Poston
Senior Counsel, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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