Grants relief after an equity agreement created a second stock class

Plain-English summary

An S corporation granted equity to a person under an agreement that provided different rights to distribution and liquidation proceeds from those held by the existing shareholders. The corporation represented that this created a second class of stock and terminated its S election. After discovering the problem, the corporation and the equity holder canceled the agreement and entered into a new one. The IRS concluded that the termination was inadvertent and granted relief under section 1362(f), allowing the corporation to be treated as continuously retaining S status. The ruling did not decide whether the replacement agreement itself created a second class of stock.

Ruling snapshot

• Question: Could the corporation receive inadvertent-termination relief after an equity agreement created a prohibited second class of stock?
• Outcome: Approved.
• Key authorities: IRC §§ 1361(a) and (b) and 1362(d) and (f); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201813003
Release Date: 3/30/2018
Third Party Communication: None
Date of Communication: Not Applicable
Index Numbers: 1361.01-04, 1362.04-00

Person To Contact:
[redacted], ID No. [redacted]
Telephone Number:
[redacted]
Refer Reply To:
CC:PSI:03
PLR-121001-17
Date:
December 21, 2017

Legend:

X = [redacted]
Shareholders = [redacted]
I = [redacted]
Agreement = [redacted]
New Agreement = [redacted]
State = [redacted]
Date 1 = [redacted]
Date 2 = [redacted]
Date 3 = [redacted]

PLR-121001-17 2

Dear [redacted]:

This letter responds to a letter dated June 30, 2017, and subsequent correspondence,
submitted on behalf of X by its authorized representative requesting a ruling under
§1362(f) of the Internal Revenue Code (Code).

FACTS

The information submitted states that X was incorporated under the laws of State on
Date 1 and elected to be an S corporation effective Date 1.

On Date 2, X and I entered into an Agreement granting equity in X to I. Although I
received equity in X, I was not entitled to the same rights to distribution and liquidation
proceeds as X’s Shareholders because under the Agreement I would only receive
proceeds upon a sale of X’s assets. X represents that the equity granted to I created a
second class of stock, and, as a result, X’s S corporation election terminated on Date 2.
Once X learned that it had a second class of stock, X and I cancelled the Agreement
and entered into a New Agreement on Date 3.

X represents that it (1) intended to be an S corporation effective Date 1 and
continuously thereafter; and (2) filed all returns consistent with being an S corporation
since Date 1. In addition, X and Shareholders agree to make any adjustments
consistent with the treatment of X as an S corporation as may be required by the
Commissioner with respect to the period specified by §1362(f).

PLR-121001-17 3

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 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 first day of the first 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 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

PLR-121001-17 4

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 2 because X had more than one class of stock
as a result of its Agreement with I. We also conclude that such termination was
inadvertent within the meaning of §1362(f). Thus, X will be treated as continuing to be
an S corporation from Date 2 and thereafter, provided X’s S corporation election was
otherwise valid and 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. In particular, we express or imply no opinion regarding whether the New
Agreement creates a second class of stock.

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.

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.

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

Sincerely,

Mary Beth Carchia
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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

cc: