Shareholder agreement caused inadvertent S election termination

Plain-English summary

An S corporation had voting and nonvoting common shares with otherwise identical rights. Its shareholders later entered an agreement that could alter their relative rights to distributable earnings and give one shareholder a larger payment if the corporation were sold. Those binding provisions created a second class of stock and terminated the S election, even though no shares were sold while they were in effect. The shareholders amended the agreement to remove the provisions, and the corporation represented that the problem was inadvertent, not tax-motivated, and that all returns had consistently treated it as an S corporation. The IRS granted inadvertent-termination relief under section 1362(f), allowing continuous S status if the corporation remained otherwise eligible.

Ruling snapshot

• Question: Did the shareholder agreement terminate the S election, and if so, was the termination inadvertent?
• Outcome: the agreement caused a termination, but inadvertent-termination relief preserved S status
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d)(2), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201919005                                            Third Party Communication: None
Release Date: 5/10/2019                                      Date of Communication: Not Applicable
Index Number: 1361.01-04, 1362.02-00,
              1362.04-00                                     Person To Contact:
                                                             -----------------------, ID No. -------------------
------------------------------------------------             ---------------------------------------------------
----------------------------------------                     Telephone Number:
--------------------------------------                       ----------------------
-------------------------------                              Refer Reply To:
                                                             CC:PSI:B01
                                                             PLR-120266-18
                                                             Date:
                                                             November 19, 2018




LEGEND:


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

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

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

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

A                 = --------------------------

B                 = ------------------------

C                 = --------------------------

Date 3            = ----------------------

g                 = ----------

h                 = ----------

Date 4            = ------------------------

Agreement         = ----------------------------------------------------------------------------------------------------------------
                    ------------------------------------------------------------------------------------------------

Date 5            = --------------
PLR-120266-18                                           2

Amendment            ----------------------------------------------------------------------------------------------------------------
                     ---------------------------------------------



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

This letter responds to a letter dated June 21, 2018, and subsequent correspondence,
submitted on behalf of X requesting rulings under § 1362(f) of the Internal Revenue
Code.

Facts

The information submitted states that X was incorporated under the laws of State on
Date 1, and elected to be treated as an S corporation effective Date 2. X has
outstanding voting and non-voting shares of the same class of common stock. Other
than the difference in voting rights, there is no difference between the voting and non-
voting shares of common stock. A, B, and C have been the only shareholders of X since
Date 3; A and B each own g% of the shares and C owns h% of the shares.

On Date 4, X’s shareholders entered into Agreement. Agreement provided that: (1) if a
shareholder’s voting stock is sold, a corresponding percentage of such shareholder’s
non-voting stock must be cancelled, and in the event that the remaining shareholders
have other than equal ownership of the remaining shares of non-voting stock, those
shareholders would be entitled to distributable earnings pro rata in accordance with the
shares of non-voting stock; and (2) in the event of a sale of X, C would be entitled to
receive from the proceeds a payment in excess of the payments to A and B. On Date 5,
the Agreement was amended to remove these two provisions. No shares of X were sold
between Date 4 and Date 5.

X represents that the circumstances resulting in the possible termination of X’s S
corporation election were inadvertent and not motivated by tax avoidance. X further
represents that since Date 2, X and its shareholders have filed all returns consistent
with X’s status as an S corporation. X and its shareholders have agreed to make such
adjustments consistent with the treatment of X as an S corporation as 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 such year.
PLR-120266-18                                 3

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 that a corporation
generally is 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.
Differences in voting rights among shares of stock of a corporation are disregarded in
determining whether a corporation has more than one class of stock. Thus, if all shares
of stock of an S corporation have identical rights to distribution and liquidation proceeds,
the corporation may have voting and nonvoting common stock.

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 law,
and binding agreements relating to distribution and liquidation proceeds (collectively,
the governing provisions). A commercial contractual agreement, such as a lease,
employment agreement, or loan agreement, is not a binding agreement relating to
distribution and liquidation proceeds and thus is not a governing provision unless a
principal purpose of the agreement is to circumvent the one class of stock requirement
of § 1361(b)(1)(D) and § 1.1361-1(l).

Section 1362(d)(2) provides that (A) in general, 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 and (B) any termination under § 1362(d)(2) shall be effective on
and after the date of cessation.

Section 1362(f) provides 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 for which the election was made or the termination occurred is a
small business corporation 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) as may be required by the Secretary with
PLR-120266-18                                  4

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.

Conclusion

Based solely on the facts submitted and representations made, we conclude that X’s S
corporation election terminated on Date 4 due to the provisions in the Agreement.
However, we conclude that such termination was inadvertent within the meaning of
§ 1362(f). Therefore, pursuant to the provisions of § 1362(f), X will be treated as an S
corporation from Date 4 to Date 5 and thereafter, provided that X is otherwise eligible to
be an S corporation and provided that the election was not otherwise terminated.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. In particular, no opinion is expressed on whether X otherwise qualifies as an
S corporation.

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, a copy of this letter is
being sent to your authorized representatives.


                                       Sincerely,


                                       David R. Haglund
                                       David R. Haglund
                                       Branch Chief, Branch 1
                                       (Passthroughs & Special Industries)



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


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