Inadvertent-invalidity relief for an S election spoiled by operating-agreement terms that created a second class of stock

Plain-English summary

A limited liability company elected to be taxed as an S corporation. To be an S corporation, a company can have only one class of stock, meaning all owners must have identical rights to distributions and liquidation proceeds. Here the company's operating agreements tied members' liquidation distributions to their individual capital accounts, which can differ from member to member. That created a prohibited second class of stock, so the S election was invalid from the start (and, if not invalid, would have terminated when a later operating agreement kept a similar provision). The company fixed the problem by adopting an amended and restated operating agreement that removed the capital-account-based liquidation language, and it asked the IRS for relief under Section 1362(f). The IRS granted relief. It found the invalid election and termination were inadvertent and not motivated by tax avoidance, that the company took corrective steps within a reasonable time, and that the company and its owners agreed to any adjustments the IRS may require. So the company is treated as an S corporation from the original effective date and thereafter, provided the election is otherwise valid.

Ruling snapshot

• Question: Was an S election that was invalid (or terminated) because operating-agreement provisions created a second class of stock eligible for inadvertent-invalidity relief under § 1362(f)?
• Outcome: Approved (relief granted; treated as an S corporation from the original effective date)
• Key authorities: IRC § 1362(f); IRC § 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: 202047001 Third Party Communication: None
Release Date: 11/20/2020 Date of Communication: Not Applicable
Index Number: 1362.00-00
Person To Contact:
-------------------------------------------------- ------------------------, ID No. -----------------
--------------------------- Telephone Number:
---------------------------- --------------------
----------------------------------------------- Refer Reply To:
---------------------------------------- CC:PSI:B01
PLR-100502-20
Date:
July 06, 2020

LEGEND

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

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

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

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

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

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

Date 5 = -------

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

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

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

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

Agreement 2 = -----------------------------------------------------------
PLR-100502-20 2

Agreement 3 = ------------------------------------------------------------------------------------------------

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

This letter responds to a letter dated December 12, 2019, 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 limited liability
company under the laws of State. A was the sole member of X.
Effective on Date 2, A signed an operating agreement, Agreement 1. Agreement 1
included provisions that created a second class of stock. Agreement 1 included the
following provisions: (1) Section 7.1 providing, in part, “A Member which withdraws
pursuant to Section 7.1 shall be entitled to a distribution in an amount equal to such
Member’s Capital Account; (2) Section 2.3, provided, “Individual capital accounts may
be maintained for each Member consisting of that Member’s Capital Contribution, (1)
increased by that Member’s share of profits, (2) decreased by that Member’s share of
losses and company expenses, (3) deceased by that Member’s distributions, and (4)
adjusted as required in accordance with applicable law.
On Date 3, A filed Form 2553, Election by a Small Business Corporation, for X to be
treated as an S corporation. The provisions of Agreement 1 applied during the period
when X intended to be treated as an S corporation until Date 4, when Agreement 2
replaced Agreement 1. At some point prior to Date 5, A transferred 50% of his interest
in X to B. Effective on Date 4, A and B signed a new operating agreement, Agreement

2. Agreement 2 included provisions that created a second class of stock. Agreement 2
   included the following provisions: (1) Section 9 provides, in part, that “After paying or
   providing for the payment of all Company debts, the proceeds of sale shall be
   distributed to the Members in accordance with their Capital Accounts.” The term
   “Capital Account” was not defined in Agreement 2.
   The provisions from Agreement 2 applied from Date 4, 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 was inadvertently invalid on Date 3 due to Agreement 1 creating a second
   class of stock and, if not inadvertently invalid, that its S election terminated on Date 4
   due to the creation of a second class of stock.
   X represents that the following corrective action was taken: on Date 6, A and B
   executed an amended and restated operating agreement for X, Agreement 3.
   PLR-100502-20 3

Agreement 3 included language that eliminated the issues relating to liquidating
distributions being based on capital accounts.
X requests two rulings. First, due to the provisions of Agreement 1, X's S election was
inadvertently invalid within the meaning of § 1362(f), and X will be treated as an S
corporation from Date 3 and thereafter. Second, 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 4 and thereafter.
X represents that the 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.
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,
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
PLR-100502-20 4

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 X's S
election was inadvertently invalid on Date 3 because X had more than one class of
stock due to provisions in Agreement 1. If X's S election was not inadvertently invalid on
Date 3, X's S election would have terminated on Date 4 because X had more than one
class of stock due provisions in Agreement 2.
We conclude that the termination of X's S election, as a result of Agreement 1 creating a
second class of stock, was inadvertently invalid 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 and has not terminated under § 1362(d).
Except as specifically ruled above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provisions of
the Code. Specifically, we express or imply no opinion as to whether X was otherwise
eligible to be treated 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 ruling request, it is subject to verification on examination.
PLR-100502-20 5

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.
In accordance with a power of attorney on file with this office, we are sending a copy of
this letter to X's authorized representatives.

                                              Sincerely,


                                              Laura C. Fields
                                              Senior Technician Reviewer, Branch 1
                                              Office of the Associate Chief Counsel
                                              (Passthroughs and Special Industries)

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

cc: