Defective governing terms and missing consent did not prevent S status

Plain-English summary

A company's S corporation election was ineffective because its operating agreement created more than one class of stock and one shareholder did not sign Form 2553. A later amendment left the same unequal distribution and liquidation terms in place, but the company eventually amended the agreement so all units had identical rights. The company and its shareholders had consistently filed as an S corporation and represented that they did not intend to terminate that status. The IRS treated the ineffective election as inadvertent under section 1362(f) and recognized S corporation status from the intended effective date. As a condition, every shareholder who had not signed Form 2553 had to submit the required consent statement within 120 days.

Ruling snapshot

• Question: May the company be treated as an S corporation despite unequal governing terms and a missing shareholder consent?
• Outcome: approved (missing shareholder consents had to be filed within 120 days)
• Key authorities: IRC §§ 1361(a) and (b), and 1362(a), (d), and (f); Treas. Reg. §§ 1.1361-1(l) and 1.1362-6(b)(1)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 202019007
Third Party Communication: None
Release Date: 5/8/2020
Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.02-02,
1361.01-04
Person To Contact:
------------------, ID No. -----------------
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Telephone Number:
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Refer Reply To:
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CC:PSI:B01
PLR-111829-19
Date:
November 29, 2019

LEGEND

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

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

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

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

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

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

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

This responds to a letter dated May 17, 2019, submitted on behalf of X by X’s authorized representative, requesting relief under § 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted and representations within, X was formed on Date 1, under the laws of State. Effective Date 2, X elected to be treated as an S corporation.

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On Date 2, X’s operating agreement contained terms causing X to have more than one class of stock. Specifically, the agreement provided for the maintenance of capital accounts for each member with each account adjusted for capital contributions, income, gain, loss, deductions, and distributions made to the member. The capital accounts were not proportionate to membership interests. The agreement also provided that liquidation proceeds were to be distributed in accordance with capital accounts rather than pro rata based on membership interests. In addition, on Date 2, X’s Form 2553 was missing the signature of one of X’s shareholders. Thus, X’s S election on Date 2 was ineffective.

On Date 3, X amended its operating agreement. However, the operating agreement still contained the same terms that caused X to have more than one class of stock. Thus, had X’s S corporation election not been ineffective on Date 2, X’s S corporation election would have terminated on Date 3.

X represents that it has taken corrective action by amending its operating agreement on Date 4 to provide that all outstanding units in X have identical distribution and liquidation proceeds.

X represents that neither X nor its shareholders intended to terminate X’s S election and that X and its shareholders have filed consistently with X being an S corporation. In addition, X represents that, other than the ineffective S election on Date 2 and the potential termination due to a second class of stock on Date 3, X has qualified as a small business corporation at all times since its election on Date 2. Lastly, X and its shareholders agree to make any adjustments required as a condition of obtaining relief under the inadvertent termination rule as provided under § 1362(f) 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 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, and 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 1 class of stock.

Section 1362(d)(2)(A) 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. Section 1362(d)(2)(B) further provides that the termination shall be

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effective on and after the date of cessation.

Treas. Reg. § 1.1361-1(I)(1) of the Income Tax Regulations provides 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(I)(2)(i) provides, in part, 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). Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing and amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a) by any corporation 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; (2) the Secretary determines that the circumstances resulting in such ineffectiveness were inadvertent; (3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness, steps were taken so that the corporation for which the election was made is a small business corporation; and (4) the corporation for which the election was made, and each person who was a shareholder in such corporation at any time during the period specified pursuant to § 1362(f), agrees to make the adjustments (consistent with the treatment of such corporation as an S corporation) as may be required by the Secretary with respect to such period, then, notwithstanding the circumstances resulting in such ineffectiveness, such corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

Based on the facts submitted and the representations made, we conclude that X’s S election was ineffective on Date 2, and the ineffectiveness of X’s S corporation election was inadvertent within the meaning of § 1362(f). Therefore, X will be treated as an S corporation effective Date 2 and thereafter, provided X’s S election is not otherwise terminated under § 1362(d).

As a condition of this ruling, any shareholder of X that did not sign X’s Form 2553 must sign a written statement as described in § 1.1362-6(b)(1) consenting to X's S election effective Date 2. The written statement(s) must be filed with the appropriate service center within 120 days from the date of this letter, indicating that the statement(s) are to be associated with X's originally filed Form 2553.

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Except as specifically ruled upon above, we express or imply no opinion concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S corporation.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3), 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 the power of attorney on file with this office, we are sending a copy of this letter to your authorized representative.

Sincerely,

Joy C. Spies
Joy C. Spies
Senior Technician Reviewer, Branch 1
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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

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