LLC receives inadvertent S corporation relief after operating agreements created multiple stock classes

Plain-English summary

An LLC intended to be an S corporation, but its operating agreement required
capital-account-based liquidating distributions and special allocations that
created more than one class of stock. Later versions retained those terms, and
the LLC also authorized and issued profits interests that created another
second class. After discovering the problem, the LLC canceled the profits
interests and amended the agreement to remove the offending provisions. The
LLC and its shareholders had consistently filed as an S corporation and agreed
to make any required adjustments. The IRS treated the original election's
ineffectiveness and the later potential terminations as inadvertent under IRC
§ 1362(f), allowing S corporation status from the intended effective date
forward, assuming no other termination occurred.

Ruling snapshot

• Question: May the LLC receive § 1362(f) relief for an ineffective S
  election and later terminations caused by multiple classes of stock?
• Outcome: Approved
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(a), (d), (f); Treas. Reg.
  § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202042008 Third Party Communication: None
Release Date: 10/16/2020 Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.04-00
Person To Contact:
----------------------- -------------------, ID No. -----------------
----------------------------------------------- Telephone Number:
-------------------------------------------- --------------------
------------------------------ Refer Reply To:
CC:PSI:B03
PLR-103934-20
Date:
July 13, 2020

LEGEND:

X: -----------------------
------------------------

Date 1: -----------------------

Date 2 : ---------------------

Date 3: ----------------

Date 4: --------------------

Date 5: ----------------------

Date 6: -----------------------

A: -----------------------

State: ----------

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

  This letter responds to a letter dated February 11, 2020, and subsequent

correspondence, submitted on behalf of X by X’s representatives, requesting relief
under § 1362(f) of the Internal Revenue Code (Code).

                                              FACTS

PLR-103934-20 2

   The information submitted states that X was formed on Date 1 under the laws of

State and elected to be treated as an S corporation effective Date 2. X’s operating
agreement effective Date 2 contained terms causing X to have more than one class of
stock under § 1361(b)(1)(D). Specifically, the agreement provided for the maintenance
of capital accounts in accordance with § 704(b) and required X to make certain special
allocations to the extent necessary to satisfy the alternate test for substantial economic
effect. The agreement further required X to make liquidating distributions in proportion
to each member’s positive capital account balance rather than pro rata based on
membership interests. Thus, X’s S corporation election effective Date 2 was
ineffective.

   On Date 3 and Date 4, X amended and restated its operating agreement.

However, the amended and restated operating agreements still contained the same
terms that caused X to have more than one class of stock on Date 2. Additionally, on
Date 5, X further amended and restated its operating agreement to authorize the
creation of profits interest units, thus creating an additional second class of stock. Also,
on Date 5, X issued profits interest units to A, an individual. Thus, had X’s S
corporation election been effective on Date 2, it would have terminated on Date 3, Date
4, and Date 5 as a result of X having more than one class of stock under
§ 1361(b)(1)(D) had it not otherwise terminated on each of those dates.

    X represents that once it learned that its S corporation was ineffective, it

cancelled A’s profits interest units and amended and restated its operating agreement
effective Date 6 to remove the terms causing X to have more than one class of stock
under § 1361(b)(1)(D).

    X represents that the circumstances surrounding X’s ineffective S corporation

election, as well as any subsequent termination, were inadvertent and unintended. X
further represents that for each taxable year since Date 2, X and its shareholders have
filed consistently with X being an S corporation. In addition, 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, a
PLR-103934-20 3

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

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

  Section 1362(a)(1) provides that, except as provided in § 1362(g), a small

business corporation may elect to be an S corporation.

   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 effective on and after the date of cessation.

   Section 1362(f) provides, in relevant part, 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 (B) was terminated under § 1362(d)(2), (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 so that
the corporation for which the election was made or the termination occurred is a small
business corporation, 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 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 the representations made, we conclude

that X’s S corporation election was ineffective on Date 2 as a result of X having more
than one class of stock. In addition, we conclude that had X’s S corporation election
been effective, it would have terminated on Date 3, Date 4, and Date 5 as a result of X
PLR-103934-20 4

having more than one class of stock had it not otherwise terminated on each of those
dates. We conclude, however, that the ineffectiveness and terminations described in
this paragraph were inadvertent within the meaning of §1362(f). Therefore, under
§ 1362(f), X will be treated an S corporation effective Date 2 and thereafter, provided
that its S corporation election has not terminated under § 1362(d) other than as
discussed in this letter.

   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. Specifically, we express or imply no opinion on whether X is
otherwise eligible 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 this request, it is subject to verification on examination.

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

provides that this ruling may not be used or cited as precedent.

   Pursuant to a power of attorney on file with this office, a copy of this letter is

being sent to your authorized representatives.

                                           Sincerely,


                                           Mary Beth Carchia
                                           Senior Technician Reviewer, Branch 3
                                           Office of the Associate Chief Counsel
                                           (Passthroughs and Special Industries)

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

cc: