Company receives S corporation relief after fixing its liquidation provisions

Plain-English summary

A company intended to elect S corporation status, but its operating agreement required liquidating distributions according to positive capital-account balances rather than ownership percentages. Those unequal liquidation rights created a second class of stock, so the S election was ineffective from its intended start date. After discovering the problem, the company amended and restated the agreement to remove the offending provisions. The company and its shareholders represented that they had consistently filed as an S corporation and agreed to make any required adjustments. The IRS granted relief under IRC § 1362(f), treating the company as an S corporation from the intended effective date if its election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Can the company's S election be treated as effective despite second-class-of-stock terms in its original operating agreement?
• Outcome: Approved as an inadvertent ineffective election
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

 Internal Revenue Service                                        Department of the Treasury
                                                                 Washington, DC 20224

 Number: 202110002                                               Third Party Communication: None
 Release Date: 3/12/2021                                         Date of Communication: Not Applicable
 Index Number: 1362.04-00
                                                                 Person To Contact:
 ----------------------------------                              -------------------, ID No. ---------------
 ----------------------------------------------------------      Telephone Number:
 ------------------------------------------                      --------------------
 ------------------------------------------                      Refer Reply To:
                                                                 CC:PSI:B03
                                                                 PLR-111468-20
                                                                 Date:
                                                                 November 2, 2020




LEGEND:

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

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

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

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

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


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

       This letter responds to a letter dated March 19, 2020, and subsequent
correspondence, 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 that X was formed on Date 1 under the laws of
State and elected to be classified 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 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.
PLR-111468-20                                 2


       X represents that once it learned that its S corporation election was ineffective, it
amended and restated its operating agreement on Date 3 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 were inadvertent and unintended. X further represents that for each taxable
year beginning 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 that
may be required by the Secretary as a condition of obtaining relief under § 1362(f).


                                  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
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 part, that if (1) an election under § 1362(a) by any
PLR-111468-20                                3

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. We conclude, however, that the circumstances resulting in the
ineffectiveness 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 is otherwise valid and has not otherwise terminated under
§ 1362(d).

       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 the ruling request, it is subject to verification on examination.
PLR-111468-20                                 4


       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.

        Pursuant to a power of attorney on file with this office, we are sending a copy of
this letter to your authorized representative.


                                                  Sincerely,




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




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


cc: