A liquidation provision that created a second class of stock made an S election invalid, but the IRS treats the defect as inadvertent

Plain-English summary

An S corporation may have only one class of stock, meaning all shares must confer
identical rights to distributions and liquidation proceeds. Here an LLC elected to
be taxed as an S corporation, but its operating agreement said liquidation
proceeds would be distributed by capital account rather than by ownership
percentage. That provision gave the shares different liquidation rights, a
prohibited second class of stock, so the S election was invalid from the start.
The company had been formed intending partnership treatment (where the provision
was harmless) and only later discovered the problem, after which it amended the
agreement to fix it. The IRS ruled the defect was "inadvertent" within the meaning
of § 1362(f) because it was not motivated by tax avoidance and was corrected once
found. As a result, the company is treated as a valid S corporation from the
original effective date forward, provided shareholders make any adjustments the
IRS requires.

Ruling snapshot

• Question: Was the company's invalid S election (caused by a second class of stock) an inadvertent defect that can be cured under § 1362(f)?
• Outcome: Approved (treated as an S corporation from the original effective date)
• Key authorities: IRC §§ 1362(f), 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                          Department of the Treasury
                                                                  Washington, DC 20224

Number: 201840004                                                 Third Party Communication: None
Release Date: 10/5/2018                                           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:B03
                                                                  PLR-107251-18
                                                                  Date:
                                                                  July 05, 2018


LEGEND

X                 =        ------------------------------------
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State1            =        -----------

State2            =        -----------------

Date1             =        ---------------------------

Date2             =        ----------------------

Date3             =        --------------------

Date4             =        --------------------

Date5             =        ------------------------

Year              =        -------



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

       This responds to a letter dated December 15, 2017, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
a ruling under §1362(f) of the Internal Revenue Code (“Code”).


                                          FACTS

        The information submitted states that X was formed under the laws of State1 on
Date1 as a limited liability company, and elected to be classified as an association
taxable as a corporation and also elected to be an S corporation effective on Date2. At
the time of formation, the members of X adopted an operating agreement that included
a provision providing for an order of priority for distributing the assets of X upon
liquidation (“Liquidation Provision”). According to the submission, the Liquidation
Provision provided for the distribution of liquidation proceeds in accordance with capital
accounts, whereby distributions made by X potentially would not be made to the
shareholders of X in accordance with their respective ownership percentages. As a
result, the outstanding shares of stock of X did not possess identical rights to
distribution and liquidation proceeds. Accordingly, X represents that X did not meet the
requirement that it have one class of stock under section 1361(b)(1)(D) on the effective
date of its S election on Date2.

        The submission further indicates that X was initially formed with the intention that
X would be treated as a partnership for federal tax purposes and, therefore, the
Liquidation Provision did not present any tax issues at that time. On Date3, the
shareholders of X adopted an amended operating agreement whereby X admitted new
shareholders and changed from a member-managed limited liability company to a
manager-managed limited liability company. The amended operating agreement also
contained the Liquidation Provision. On Date4, the shareholders of X adopted a second
amended operating agreement whereby X admitted new shareholders, among other
things. Although the distribution of proceeds upon the liquidation of X was slightly
modified in the second amended operating agreement, the agreement still contained the
Liquidation Provision. On Date5, X filed Articles of Conversion whereby X converted
from a State1 limited liability company to a State2 limited liability company. The Plan of
Conversion provided that all ownership interests in X would remain the same as those
prior to the conversion.

       When X’s owners became aware of the second class of stock issue in Year, they
sought tax counsel to assist with amending X’s operating agreement to modify the
Liquidation Provision to provide that, upon liquidation of X, distributions be made in
accordance with the ownership percentages in X, not capital accounts.

        X represents that X and X’s shareholders have filed tax returns consistent with X
being an S corporation since Date2. X further represents that the circumstances
resulting in the ineffectiveness of X’s S corporation election were inadvertent and were
not motivated by tax avoidance or retroactive tax planning. X and each person who was
or is a shareholder of X at any time since Date2 agree to make any adjustments
(consistent with the treatment of X as an S corporation) as may be required by the
Secretary with respect to such period. X further represents X has taken all of the

necessary corrective steps to rectify the ineffectiveness of X’s S corporation election.
Specifically, X represents that X has amended its operating agreement to remove all
provisions that could create a second class of stock.

                                   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 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 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, the governing provisions).

      Section 1362(a)(1) provides that, except as provided in § 1362(g), a small
business corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

       Section 1362(d)(2) provides that 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. A termination of an S corporation election under § 1362(d)(2) is effective
on or after the date of cessation.

       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 such 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 corporationor 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 § 1362(f), 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.

                                     CONCLUSION

       Based solely on the facts submitted and the representations made, we conclude
that X’s S corporation election was ineffective on Date2 as a result of the second class
of stock due to the Liquidation Provision contained in X’s operating agreement. We
conclude that this ineffectiveness was inadvertent within the meaning of § 1362(f).
Pursuant to the provisions of § 1362(f), X will be treated as an S corporation beginning
on Date2 and continuing thereafter, unless X’s S corporation election otherwise
terminated under §1362(d) for other reasons.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the federal tax consequences of any aspect of any transaction or item
discussed or referenced in this letter. Specifically, no opinion is expressed or implied
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 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 request for a ruling, it is subject to verification on examination.

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

        In accordance with the Power of Attorney on file with this office, copies of this
letter are being sent to your authorized representatives.



                                       Sincerely,



                                       Caroline E. Hay
                                       Assistant to the Branch Chief
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)

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