Corporation receives inadvertent-election relief after consent, stock-class, and allocation defects

Plain-English summary

A corporation's S election was ineffective because it did not obtain every required shareholder consent. Its original operating agreement also created a second class of stock, and the corporation made disproportionate distributions and failed to allocate tax items pro rata among shareholders. After discovering the problems, it adopted a new operating agreement, made corrective distributions, and began amending its returns to correct shareholder allocations. The corporation represented that the failures were inadvertent and not motivated by tax avoidance or retroactive planning. The IRS granted section 1362(f) relief and treated the corporation as an S corporation from the intended effective date, conditioned on amended returns for all open years allocating every tax item pro rata. The IRS did not otherwise decide whether the corporation qualified for S status.

Ruling snapshot

• Question: Can a corporation preserve S status after missing shareholder consents, creating a second stock class, and making disproportionate distributions and allocations?
• Outcome: approved, subject to amended returns with pro rata allocations
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201804001                                              Third Party Communication: None
Release Date: 1/26/2018                                        Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-01
                                                               Person To Contact:
----------------------------------------------                 ------------------------------,
-----------------------------------------------------          ID No. ----------------
------------------------------------                           Telephone Number:
--------------------------------------                         ----------------------
                                                               Refer Reply To:
                                                               CC:PSI:B01
                                                               PLR-115200-17
                                                               Date:
                                                               October 26, 2017

LEGEND

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

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

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

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


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

       This responds to a letter dated May 3, 2017, and supplemental correspondence,
submitted on behalf of X, by X's authorized representative, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code).

Facts

      According to the information submitted and representations made within, X was
formed under the laws of State and made an S election effective Date 1.

        X's S corporation election was ineffective because X failed to obtain all required
shareholder consents to the election. Additionally, X represents that its original
operating agreement created a second class of stock causing its S election to be
invalid. X also made disproportionate distributions and did not allocate its income and
other tax items pro rata among its shareholders. X represents that during Date 2 it
discovered that its S election was invalid. X took corrective action by adopting a new
operating agreement eliminating the provisions that caused X to have a second class of
stock, and by making corrective distributions. X also represents that it is amending its
tax returns to allocate the correct amounts to each shareholder.

PLR-115200-17                               2


       X represents that its invalid 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.

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 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 taxable year for which
the corporation is an S corporation) such corporation ceases to be a small business
corporation.

       Section 1362(f) provides that if (1) an election under subsection (a) or section
1361(b)(3)(B)(ii) by any corporation (A) was not effective for the taxable year for which
made (determined without regard to subsection (b)(2)) by reason of a failure to meet the
requirements of section 1361(b) or to obtain shareholder consents, or (B) was
terminated under paragraph (2) or (3) of subsection (d) or section 1361(b)(3)(C); (2) the
Secretary determines that the circumstances resulting in such ineffectiveness or
termination were inadvertent; (3) no later than a reasonable period of time after
discovery of the circumstances resulting in such 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 required shareholder consents;
and (4) the corporation for which the election was made or the termination occurred,
and each person who was a shareholder in such corporation at any time during the
period specified pursuant to this subsection, agrees to make such adjustments
(consistent with the treatment of such 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 such
ineffectiveness or termination, such corporation shall be treated as an S corporation or
a qualified subchapter S subsidiary, as the case may be during the period specified by
the Secretary.

PLR-115200-17                                 3


Conclusion

        Based solely on the facts submitted and the representations made, we conclude
that the invalidity of X’s S corporation election was inadvertent within the meaning of §
1362(f). Therefore, X will be treated as an S corporation effective Date 1 and thereafter,
provided X’s S corporation election is not otherwise terminated under § 1362(d). This
ruling is contingent on X amending its tax returns for all open years to allocate all tax
items pro rata to each of its shareholders.

         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.

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

                                          Sincerely,

                                          Joy C. Spies

                                          Joy C. Spies
                                          Senior Technician Reviewer, Branch 1
                                          Office of Associate Chief Counsel
                                          (Passthroughs & Special Industries)




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