IRS grants inadvertent-termination relief under section 1362(f) where an LLC's operating agreement created a second class of stock and voided its S election

Plain-English summary

A two-owner limited liability company that had been treated as a partnership later elected to be taxed as an S corporation. Its operating agreement, however, contained partnership-style allocation and liquidation provisions that did not give all owners identical rights to distributions and liquidation proceeds. That created a prohibited second class of stock, so the S election was void from the start (an S corporation may have only one class of stock). After discovering the problem, the company replaced the operating agreement and asked the IRS for relief under section 1362(f), representing that the defect was inadvertent and not tax-motivated and that its shareholders would make any required adjustments. The IRS granted relief. It found the ineffectiveness inadvertent, so the company will be treated as an S corporation from its intended effective date, provided the election was otherwise valid.

Ruling snapshot

• Question: Was the company's void S election (caused by an operating agreement that created a second class of stock) inadvertent, so that S status can be restored under section 1362(f)?
• Outcome: Approved (relief granted)
• 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: 202141002 Third Party Communication: None
Release Date: 10/15/2021 Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-00,
1361.01-04, 1362.00-00, Person To Contact:
1362.02-00, 1362.04-00 --------------------, ID No. -----------------
Telephone Number:
------------------------------- --------------------
------------------------------------------------------- Refer Reply To:
----------------------------------------- CC:PSI:03
--------------------------------- PLR-101968-21
Date:
July 22, 2021

Legend

Company = ----------------------------------------

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

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

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

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

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

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

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

   This letter responds to a letter dated December 15, 2020, submitted on behalf of

Company by its authorized representative, requesting a ruling under § 1362(f) of the
Internal Revenue Code (Code).

                                                   Facts

PLR-101968-21 2

     The information submitted states Company was organized on Date 1 as a limited

liability company under the laws of State. At all times Company has had two owners,
and until Date 2 was treated as a partnership. Upon organization Company adopted
Agreement 1 which included provisions treating Company as a partnership for Federal
income tax purposes. Agreement 1 included the following partnership provisions:

Section 5.3, Formula for Allocations of LLC Profits and Losses Among the

Members

  The LLC shall allocate its profits and losses to Members in proportion to their

respective contributions to the LLC unless otherwise agreed by all of the Members.

         a. Allocations in Respect of Contributed Non-Cash Property. If a Member
            makes a contribution of non-cash property to the LLC, the LLC shall
            allocate its income, gains, deductions, losses and other tax items to
            the Member in respect of this contribution in accordance with Internal
            Revenue Code Section 704 (c) (1) (A) and regulations thereunder.

         b. Allocations Disproportionate to Capital Contributions. If the LLC
            allocates any of its profits and losses to a Member in a manner that is
            disproportionate to the Member’s share of LLC contributions, the LLC
            shall make this allocation in compliance with the requirements of
            Internal Revenue Code Section 704(b) and the regulations thereunder.

  Section 5.5, Formula for Allocations of Interim Distributions Among the Members

  The LLC shall allocate Interim Distributions among Members in accordance with

the same formula on the basis of which it allocates its profits and losses among them.

   Section 5.9, Payments and Distributions of LLC Assets in Connection with

Liquidation

     Upon completion of the LLC’s winding up, and, to the extent reasonably

practicable, on or before the date of termination of the LLC’s legal existence, the LLC
shall (subject to any applicable provisions of Section 704 (b) of the Internal Revenue
Code and other applicable federal and state law) pay out its assets in connection with
its liquidation as follows:

         a. Payment of Creditors. First, the LLC shall pay (or shall make adequate
            provision to pay) its creditors.

         b. Distributions to Members of Allocated Assets. Second, the LLC shall
            distribute its assets to Members in satisfaction of its liabilities for
            Interim Distributions to them under this Agreement.

PLR-101968-21 3

          c. Distributions to Members to Return Their Contributions. Third, the LLC
             shall distribute its assets to Members for the return of their
             contributions.

          d. Distributions in Accordance with Section 5.3. Fourth, the LLC shall
             distribute its assets to Members in accordance with the allocation
             formula set forth in Section 5.3.

   Effective Date 3, Company elected to be treated as an S Corporation for Federal

income tax purposes. Agreement 1 created a second class of stock, causing
Company’s S corporation status to be void ab initio. Upon learning that Agreement 1
voided Company’s S election, Company executed Agreement 2 that replaced
Agreement 1. Company represents that the termination of Company’s S corporation
election was inadvertent and not motivated by tax avoidance. Shareholders of
Company have consented to make any adjustments as may be required by the
Secretary.

   The information provided states that on and after Date 1, the owners of Company

were all individuals who were eligible S Corporation shareholders, all income and
expense items were allocated on a per-share basis, all distributions were made on a
pro-rata basis based on ownership, and all shareholders were treated equally in
corporate matters.

  Company requests relief pursuant to § 1362(f) due to Agreement 1 having

governing provisions that created more than one class of stock.

                                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 such year.

  Section 1361(b)(1) provides that for purposes of subchapter S, the term “small

business corporation” means a domestic corporation, which is not an ineligible
corporation and does not have (A) 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 subsection § 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 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.
PLR-101968-21 4

   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(a)(1) 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 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) provides, in part, that if (1) an election under § 1362(a) by any

corporation (i) 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
(ii) was terminated under § 1362(d)(2) or (3); (2) the Secretary determines that the
circumstances resulting in such ineffectiveness or termination were inadvertent; (3) no
later than a reasonable period of time after discovery of the circumstances resulting in
such 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), agree to make the adjustments (consistent with the
treatment of the corporation as an S corporation as may be required by the Secretary
with respect to this period, then, notwithstanding the circumstances resulting in such
ineffectiveness or termination, the corporation shall be treated as an S corporation
during the period specified by the Secretary.

                                   Conclusion

   Based on the facts submitted and representations made, we conclude that

Company's S election terminated on Date 3, as Agreement 1 created more than one
class of stock. We further conclude that the termination was inadvertent within the
meaning of § 1362(f). Accordingly, under § 1362(f), Company will be treated as
continuing to be an S corporation on and after Date 3, provided that Company’s S
corporation election was valid and not otherwise terminated under § 1362(d).

   Except as specifically ruled above, we express or imply no opinion as to the

federal income tax consequences of the facts described above under any other
provision of the Code, including Company's eligibility to be a valid S corporation.

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

the Code provides that it may not be used or cited as precedent.
PLR-101968-21 5

   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.

                                 Sincerely,



                                 Richard T. Probst
                                 Senior Technician Reviewer, Branch 3
                                 Office of the Associate Chief Counsel
                                 (Passthroughs & Special Industries)

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

cc: