Inadvertent S-corporation termination from partnership-style operating agreements excused under 1362(f)

Plain-English summary

An S corporation is allowed only one class of stock, meaning all shares must confer identical rights to distributions and liquidation proceeds. Here an LLC that had elected to be taxed as an S corporation adopted operating agreements written in partnership-style language (capital-account maintenance, § 704(b)/(c) allocations, liquidation by capital-account balances). Those provisions gave the company a prohibited second class of stock, which silently terminated its S election. The company represented the termination was inadvertent and not tax-motivated, and that it had always filed as an S corporation. Under § 1362(f), the IRS can forgive an inadvertent termination and treat the company as having stayed an S corporation the whole time. The IRS agreed the termination was inadvertent and ruled that the company continues to be treated as an S corporation from the termination date forward, provided its election is otherwise valid. This is the common cure for LLCs whose "boilerplate" partnership operating agreement accidentally breaks their S-corporation status.

Ruling snapshot

• Question: Was the company's S-election termination (caused by partnership-style provisions creating a second class of stock) inadvertent, so it may be treated as continuing to be an S corporation?
• Outcome: Approved (inadvertent termination relief granted under § 1362(f))
• Key authorities: IRC §§ 1362(f), 1361(b); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202203004 Third Party Communication: None
Release Date: 1/21/2022 Date of Communication: Not Applicable
Index Number: 1361.01-04, 1361.01-05,
1362.00-00, 1362.04-00 Person To Contact:
----------------, ID No. ---------------
----------------------------------------- Telephone Number:
------------------------------------------------------------ --------------------
--------- Refer Reply To:
-------------------------------------- CC:PSI:01
------------------------------------ PLR-110363-21
Date:
August 30, 2021

                                                  Legend

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

State = ---------

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

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

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

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

Date 5 = ----------------------

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

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

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

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

This letter responds to a letter dated April 21, 2021, submitted on behalf of Company by
its authorized representative, requesting a ruling under § 1362(f) of the Internal
PLR-110363-21 2

Revenue Code (Code).

                                      Facts

The information submitted states that Company was organized under the laws of State
on Date 1 as a limited liability company. Company was originally treated as a
partnership for Federal tax purposes. Effective Date 2, Company elected to be an
association treated as an S corporation.

Effective on Date 3, Company adopted an operating agreement, Agreement 1.
Agreement 1 included provisions in contemplation of Company being treated as a
partnership for federal income tax purposes; however, the applicability of those
provisions was not limited to such a situation. Agreement 1 included the following
partnership provisions: (1) Section 7.5 providing for the maintenance of capital
accounts, the definition of which requires that the capital accounts be increased,
decreased, and otherwise maintained in accordance with § 1.704-1(b)(2)(iv) of the
Income Tax Regulations; (2) Section 7.6(a) providing that any allocations with respect to
property whose value differs from its tax basis “be allocated for federal income tax
purposes to the Interest Holders under Code § 704(b) and (c)”; (3) Sections 7.1 and 7.2
providing that, after regulatory allocations (which include allocations made pursuant to
§ 1.704-2, § 1.704-1(b)(2)(ii), and general curative allocations), profits and losses, are,
in general, allocated among Interest Holders in proportion to their Units, except that
losses may not create or increase a capital account deficit; (4) Section 7.3 providing, in
part, that distributions must be made, at minimum, to pay the Interest Holders’ tax
liabilities attributable to the Company’s income and that all distributions “must be
allocated in proportion to Unit ownership, unless the Members otherwise determine by
Majority Vote”; and (5) Section 14.2 providing that liquidating distributions shall be made
“to Interest Holders in accordance with positive Capital Account balances taking into
account all Capital Account adjustments for the Company’s taxable year in which the
liquidation occurs.”

Effective on Date 4, Company adopted another operating agreement, Agreement 2.
Agreement 2 included provisions in contemplation of Company being treated as a
partnership for federal income tax purposes; however, the applicability of those
provisions was not clearly limited to such a situation. Agreement 2 included the
following partnership provisions: (1) Section 7.4 providing for the maintenance of capital
accounts and Regulatory Allocations (which are not defined); (2) Section 7.3 providing,
in part, that distributions must be made, at minimum, to pay the Interest Holders’ tax
liabilities attributable to the Company’s income, and that all distributions “must be
allocated in proportion to Unit ownership, unless the Members otherwise determine by
Super Majority Vote”; and (3) Section 14.2 providing that liquidating distributions shall
be made “to Interest Holders in accordance with positive Capital Account balances
taking into account all Capital Account adjustments for the Company’s taxable year in
which the liquidation occurs.”
PLR-110363-21 3

On Date 5, Company adopted Agreement 3, which Company represents does not
create a second class of stock.

Company represents that the terminations of its S election were inadvertent and was
not motivated by tax avoidance or retroactive tax planning. Company also represents
that Company 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) of the Code that may be required by the Secretary. Company and its
shareholders represent that they have filed all returns consistent with Company 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) of the Income Tax Regulations 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
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.
PLR-110363-21 4

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) or (3), (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 the 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 on the facts submitted and representations made, we conclude that Company's
S election was terminated on Date 3 because Company had more than one class of
stock due to the partnership provisions in Agreement 1. If Company’s S election hadn’t
terminated on Date 3, Company’s S election would have terminated on Date 4 because
Company had more than one class of stock due to partnership provisions in Agreement
2, which was effective on Date 4.

We also conclude that the termination of Company’s S election as a result of Agreement
1 and Agreement 2 creating a second class of stock was inadvertent. Accordingly,
under § 1362(f), Company will be treated as an S corporation from Date 3, and
thereafter, provided the S election for Company is otherwise valid and has not
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, no opinion is expressed or implied concerning whether X otherwise
qualifies as an S corporation for federal tax purposes.

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.

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-110363-21 5

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

                                  Sincerely,


                                  Caroline E. Hay
                                  _________________________
                                  Caroline E. Hay
                                  Senior Counsel, Branch 1
                                  (Passthroughs and Special Industries)

Enclosure:
Copy for §6110 purposes

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