S election relief covered an ineligible owner and second stock class

Plain-English summary

An entity intended to be an S corporation, but a partnership shareholder was ineligible and did not consent to the election. Its governing agreements also used partnership-style capital accounts and allocation provisions that created a second class of stock, first making the election ineffective and later causing a potential termination. The owners corrected the shareholder issue by making the partnership a disregarded entity and later converted the taxpayer to a state-law corporation. The IRS found all three defects inadvertent and treated the taxpayer as an S corporation from the intended effective date. Relief was conditioned on filing a completed Form 2553 within 120 days.

Ruling snapshot

• Question: Could the taxpayer retain S status despite an ineligible nonconsenting shareholder and governing provisions that created a second class of stock?
• Outcome: approved, with S status recognized from the intended date if Form 2553 was filed within 120 days
• Key authorities: IRC §§ 1361(b) and 1362(f); Treas. Reg. §§ 1.1361-1(l), 1.1362-6, and 1.1377-1

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201936005                                            Third Party Communication: None
Release Date: 9/6/2019                                       Date of Communication: Not Applicable
Index Number: 1361.01-02, 1361.01-04,
              1361.01-05, 1362.00-00,                        Person To Contact:
              1362.01-00                                     ----------------, ID No. ---------------
                                                             Telephone Number:
-------------------------------------                        ---------------------
-------------------------------------------                  Refer Reply To:
--------------------                                         CC:PSI:01
-----------------------------                                PLR-131422-18
                                                             Date:
                                                             May 22, 2019




Legend

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

State                = --------

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

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

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

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

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

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

Date 7               = ---------------------------

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

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

C                    = ---------------------
PLR-131422-18                                            2

D                    = ---------------------

E                    = ------------------------------------

Agreement 1          = --------------------------------------------------------------------------------------------
                       ------------------

Agreement 2          = --------------------------------------------------------------------------------------------
                       ------------------------------------------



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

This letter responds to a letter dated October 15, 2018, 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 X was organized on Date 1 as a corporation under the
laws of State. On Date 2, A, B, C, and D, each assigned one share of X to E, which was
taxed as a partnership for U.S. federal tax purposes. Effective Date 3, X converted to a
limited partnership, organized under the laws of State. On Date 4, X elected to be taxed
as an association taxable as a corporation, effective Date 3. On Date 4, A, B, C, and D,
and their spouses holding community property interests in the X shares, filed Form
2553, Election by a Small Business Corporation, for X to be treated as an S corporation,
effective Date 3. E did not sign and submit Form 2553, although E was a shareholder
as of Date 3. As of Date 3, E was an ineligible shareholder under § 1361(b)(1)(B).

Effective on Date 3, A, B, C, D, and E signed a partnership agreement, Agreement 1.
Agreement 1 included provisions in contemplation of X being treated as a partnership
for federal income tax purposes; however, the applicability of those provisions was not
limited to such a situation. Agreement 1 included the following partnership provisions:
(1) Article IX providing for the increase, decrease, maintenance and transfer of capital
accounts in accordance with § 1.704-1(b)(2)(iv) of the Income Tax Regulations; (2)
Article X. A. providing “for federal income tax purposes, each item of income, gain, loss
and deduction will be allocated among the Partners in the same manner as its
correlative item of ‘book’ income, gain, loss or deduction is allocated pursuant to this
Article X”; (3) Article X. B. providing, in part, “[a]ll items of income, gain, loss, deduction,
and credit of the Partnership as determined for federal income tax purposes shall be
allocated among the Partners in accordance with their respective percentage
Partnership Interests”; (4) Article XI. A. providing, in part, “Distributable Cash may be
distributed at the sole discretion of the General Partner among the Partners pro rata in
PLR-131422-18                                  3

accordance with their Sharing Ratios”; and (5) Article XVII. C. providing, in part, “after all
allocations of income, gains, losses and deductions pursuant to Article X” liquidation
distributions shall be made “to the Partners in payment of the positive balances in their
Capital Accounts.” These provisions applied during the period when X intended to be
treated as an S corporation until Date 5, when Agreement 2 replaced Agreement 1.

Before Date 5, X redeemed all of D’s shares. Effective on Date 5, A, B, C, and E signed
a partnership agreement, Agreement 2. Agreement 2 included provisions in
contemplation of X being treated as a partnership for federal income tax purposes;
however, the applicability of those provisions was not limited to such a situation.
Agreement 2 included the following partnership provisions: (1) Article VIII(b)(1)
providing for the increase, decrease, maintenance and transfer of capital accounts in
accordance with § 1.704-1(b)(2)(iv) of the Income Tax Regulations; (2) Article VIII(c)(1)
providing “[e]xcept as otherwise provided, Profit and Loss for such fiscal year shall
generally be allocated among the Partners in proportion to their respective Sharing
Ratios at the time the allocation is made”; (3) Article V(l) defining, in part, “Sharing
Ratio” to mean “the ratio of a Partner’s Capital Account to the Capital Accounts of all
Partners . . . . Each Partner’s Sharing Ratio is subject to change over time as provided
in this Agreement”; (4) Article VIII(d)(1) providing, in part, “Distributable Cash, if and
when there is any, shall generally be distributed to the Partners pro rata to their
Partnership Interests at the time the distribution is made”; (5) Article V(i) defining, in
part, “Partnership Interest” to mean “the ownership interest . . . in the Partnership,
including, without limitation, his right to a distributive share of the Profits and Losses,
distributions, and the Property of the Partnership”; and (6) Article VIII(d)(3) providing
“[u]pon liquidation of the Partnership (and after adjusting Capital Accounts to reflect
unrealized gains or losses[)], the remaining Partnership property shall be distributed to
the Partners in accordance with their Capital Account balances.” These provisions
applied from Date 5, during the period when X intended to be treated as an S
corporation, until Date 6.

X represents that its S election on Date 3 may have been ineffective due to an ineligible
shareholder and a second class of stock and, if not ineffective, that its S election may
have terminated on Date 5 due to a second class of stock. X represents that the
following corrective actions were taken: (1) on Date 6, A and B assigned their
membership interests in E to C, the remaining member, causing E to be treated as an
entity disregarded from C for U.S. federal income tax purposes; and (2) on Date 7, X
converted to a corporation under the laws of State. X represents that the conversions on
Date 2 and Date 7 each qualified as an F reorganization within the meaning of §
368(a)(1)(F).

X requests three rulings. First, the ineffectiveness of the X’s S election caused by E
being taxed as a partnership on Date 3, was inadvertent within the meaning of §
1362(f), and X will be treated as an S corporation from Date 3 and thereafter. Second,
the ineffectiveness of the X’s S election due to the provisions of Agreement 1 was
PLR-131422-18                                 4

inadvertent within the meaning of § 1362(f), and X will be treated as an S corporation
from Date 3 and thereafter. Third, the termination of the X’s S election due to the
provisions of Agreement 2 was inadvertent within the meaning of § 1362(f), and X will
be treated as an S corporation from Date 3 and thereafter.

X represents that the possible ineffectiveness and termination of its 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. X and its shareholders
represent that they have filed all returns consistent with X being an S corporation.

                                     Law and Analysis

Section 1362(a) 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 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) provides that the term "small business corporation" means 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.

An S corporation election is not effective if there is an ineligible shareholder at any time
during the taxable year for which the election is to be effective. See
§ 1.1362-6(a)(2)(iii), Example 3.

A shareholder who disposes of stock in an S corporation is treated as the shareholder
for the day of the disposition. See § 1.1377-1(a)(2)(ii).

Section 1.1361-1(l)(1) 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,
PLR-131422-18                                  5

and binding agreements relating to distribution and liquidation proceeds (collectively,
governing provisions).

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 1st taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

Section 1362(f) and the regulations thereunder provide relief for an ineffective S
corporation election (i.e., treating the ineffective election as effective) or inadvertent
termination of an S corporation election provided the following conditions are met:

   a. The corporation made an election under § 1362(a) that was ineffective or was
      terminated;

   b. The Service determines that circumstances resulting in the ineffectiveness or
      termination were inadvertent;

   c. Steps were taken by the corporation to qualify it as a small business corporation
      within a reasonable period of time after discovery of the ineffectiveness or
      termination event; and

   d. The corporation and all shareholders agree to any adjustments that the Service
      may require for the period.

                                         Conclusion

Based on the facts submitted and representations made, we conclude that the S
election filed on Date 4 and intended to be effective on Date 3 was ineffective. The S
election for X was ineffective because, on Date 3, E held X shares, failed to sign and
submit Form 2553 electing S status for X, and was an ineligible S corporation
shareholder under § 1361(b)(1)(B). In addition, X's S election was ineffective because X
had more than one class of stock due to the partnership provisions in Agreement 1. If
X’s S election had been effective, X’s S election would have terminated on Date 5
because X had more than one class of stock due to partnership provisions in
Agreement 2, which was effective on Date 5.

We conclude the ineffectiveness of the S election for X, due to E being an ineligible
shareholder, was inadvertent within the meaning of § 1362(f). We also conclude that the
ineffectiveness of X's S election, as a result of Agreement 1 creating a second class of
stock, was inadvertent within the meaning of § 1362(f). We also conclude that the
termination of X’s S election, as a result of Agreement 2 creating a second class of
stock, was inadvertent. Accordingly, under § 1362(f), X will be treated as an S
corporation from Date 3, and thereafter, provided the S election for X is otherwise valid
PLR-131422-18                                 6

and has not terminated under § 1362(d). Such relief is conditioned upon filing a
completed Form 2553 to make an S election for X to be effective Date 3 with the
appropriate service center within 120 days of the date of this letter. A copy of this letter
should be attached to the submitted Form 2553.

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.

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,



                                   By: Joy Spies
                                      Joy Spies
                                      Senior Technician Reviewer, Branch 1
                                      (Passthroughs and Special Industries)

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