Partnership-style operating agreement caused inadvertent S termination

Plain-English summary

A limited liability company elected S corporation status but later adopted operating agreements containing partnership-style allocation and liquidation provisions. When a second shareholder acquired an interest, those provisions caused the company to have more than one class of stock and terminated its S election. The members removed the provisions after discovering the problem and gave all owners identical distribution and liquidation rights. Actual income allocations and distributions had been pro rata, and no federal return was filed inconsistently with continuous S status. The IRS treated the termination as inadvertent and allowed the company to remain an S corporation, assuming its election was otherwise valid and not otherwise terminated.

Ruling snapshot

• Question: Could the S corporation receive inadvertent-termination relief after its operating agreement created unequal distribution or liquidation rights?
• Outcome: Approved; the company is treated as an S corporation continuously from the termination date, subject to the ruling's conditions.
• Key authorities: IRC §§ 1361 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: 201822003 Third Party Communication: None
Release Date: 6/1/2018 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
Person To Contact:
--------------------------------, --------------------------- --------------------, ID No. ------------------
---------------------------------------------------------- Telephone Number:
-------------------------------- ----------------------
-------------------------------------------------- Refer Reply To:
--------------------------------- CC:PSI:01
PLR-126814-17
Date:
February 23, 2018

LEGEND

Company = ---------------------------------------------------------------------------------------------
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State = ----------------
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Agreement 1 = ---------------------------------------------------------------------------------------------
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Agreement 2 = ---------------------------------------------------------------------------------------------
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Agreement 3 = ---------------------------------------------------------------------------------------------
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Agreement 4 = ---------------------------------------------------------------------------------------------
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Date 1 = -------------------
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Date 2 = ---------------------------------------------------------------------------------------------
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Date 3 = ---------------------------------------------------------------------------------------------
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Date 4 = --------------------

Date 5 = ---------------------------

Date 6 = ----------------------

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

This letter responds to a letter dated August 29, 2017, and subsequent correspondence
submitted on behalf of Company requesting a ruling under § 1362(f) of the Internal
Revenue Code (Code).

                                     FACTS

According to the information submitted, Company was organized as a limited liability
company under the laws of State on Date 1. Subsequently, Company made an election
to be treated as an S corporation effective Date 2.

Company’s single shareholder signed an operating agreement, Agreement 1.
Agreement 1 included provisions allocating Company profits, losses, and distributions to
Members in proportion to their relative Membership interests.

On Date 3, Agreement 1 was replaced by Agreement 2. Agreement 2 included
provisions regarding partnerships, including Section 4.3, which incorporated by
reference the qualified income offset, minimum gain chargeback and partner minimum
gain chargeback provisions under § 704(b). Section 4.3.2 provided, in part, for special
allocations as provided in § 704(c) in the case of property that was contributed to
Company in-kind, as well as for “reverse” § 704(c) allocations if the book value of
Company assets was adjusted. Section 4.3.3 provided, in part, for special allocation of
gain or loss resulting from a § 754 election. Section 4.4 provided, in part, that if
Company was liquidated, assets of Company were to be distributed to the Members of
Company in accordance with the balances in their respective capital accounts.

On Date 4, a second shareholder acquired interests in Company. On Date 5,
Agreement 2 was replaced by Agreement 3. Agreement 3 included language making
Company a “benefit corporation” and an update to the schedule of members to reflect
the issuance of units to an additional shareholder. Agreement 3 included the same
partnership provisions that were in Agreement 2.

When Company's members discovered the effect of the partnership provisions in
Agreement 3, they amended the operating agreement into Agreement 4, effective Date
6, to remove the provisions and provide identical distribution and liquidation rights to
Company's members.

Company represents that the termination of the S corporation was inadvertent and not
the result of tax avoidance or retroactive tax planning. Company further represents that
no federal tax return of any person has been filed inconsistent with a valid S corporation
election having been made for Company effective Date 2. Company also represents

that all distributions and allocations of income to its shareholders have been made pro
rata in accordance with their interests in Company. Company and its shareholders have
agreed to make any adjustments required by the Service consistent with the treatment
of Company 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(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
Company's S corporation election terminated on Date 4 for having more than one class
of stock due to the partnership provisions in Agreement 2, which were repeated in
Agreement 3. We also conclude that the circumstances resulting in the termination of
Company's S corporation election were inadvertent within the meaning of § 1362(f).
Thus, under the provisions of § 1362(f), Company will be treated as an S corporation
effective Date 4, and thereafter, provided that Company'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 Company was otherwise
eligible to be an S corporation.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) 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
Company'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,

                                             Joy C. Spies

                                             Joy C. Spies
                                             Senior Technician Reviewer, Branch 1
                                             (Passthroughs and Special Industries)

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