Inadvertent-termination relief after an LLC operating agreement's partnership provisions created a second class of stock

Plain-English summary

An S corporation converted into an LLC but kept being taxed as a corporation, and then adopted an operating agreement written with partnership-style provisions: capital accounts maintained under the section 704(b) rules, special tax allocations under section 704(c), and liquidating distributions based on each member's capital account balance rather than strictly per share. Those provisions meant the shares no longer conferred identical rights to distributions and liquidation proceeds, so the company was treated as having more than one class of stock, which an S corporation cannot have. That defect terminated the S election. The company asked the IRS for relief under section 1362(f), representing the termination was inadvertent and not tax-motivated and that everyone had kept filing as an S corporation. The IRS agreed the second-class-of-stock problem was inadvertent and ruled the company will be treated as continuing to be an S corporation from the termination date forward. This is a common trap: boilerplate partnership language in an LLC agreement can quietly break S corporation status.

Ruling snapshot

• Question: Was the S election's termination inadvertent when the LLC's operating agreement created a prohibited second class of stock, and can section 1362(f) restore S status?
• Outcome: Approved (treated as a continuing S corporation from the termination date).
• Key authorities: IRC § 1362(f); IRC § 1361(b)(1)(D) (one class of stock); IRC § 1362(d)(2); Treas. Reg. § 1.1361-1(l).

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202209001                                              Third Party Communication: None
 Release Date: 3/4/2022                                         Date of Communication: Not Applicable
 Index Number: 1361.01-04, 1361.01-05,
               1362.02-02, 1362.04-00                           Person To Contact:
                                                                ---------------------------, ID No. ---------------
 -------------------------------                                -----------------
 ----------------------------                                   Telephone Number:
 ---------------------------------                              --------------------
 ------------------------                                       Refer Reply To:
 ----------------------------                                   CC:PSI:01
                                                                PLR-103324-21
                                                                Date:
                                                                September 09, 2021




                                                     Legend

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

 State                =      ------

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

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

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

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

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

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


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

This letter responds to a letter dated January 29, 2021, submitted on behalf of Company
by its authorized representative, requesting a ruling under § 1362(f) of the Internal
Revenue Code (Code).

                                                      Facts
PLR-103324-21                                2

 The information submitted states that Company was organized under the laws of State
on Date 1 as a corporation and elected to be treated as an S corporation effective Date
1.

Effective on Date 2, Company converted to a limited liability company and continued to
be treated as a corporation for federal income tax purposes. 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 3.6
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) of the Income Tax Regulations; (2) Section 4.8 providing that, "[i]n
accordance with Code Section 704(c) and the Regulations thereunder, income, gain,
loss, and deduction with respect to any property contributed to the capital of the
Company shall, solely for tax purposes, be allocated among the Members to as to take
account of any variations between adjusted basis of such property to the Company for
federal income tax purposes and its initial Gross Asset Value"; (3) Section 4.2 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 Members in proportion to their respective Company Units, except that,
pursuant to Section 4.5, losses may not create or increase a capital account deficit; (4)
Section 4.1 providing, in part, that distributions must be made, at minimum, in an
amount equal to the lesser of all available Net Cash Flow or a percentage of Company
net taxable income equal to the highest marginal tax effected state and federal income
tax rates applicable to any Member; and (5) Section 11.2 providing that liquidating
distributions shall be made "to Members in proportion to and to the extent of their
positive Capital Account balances, after giving effect to all contributions, distributions
and allocations for all periods."

On Date 4, 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
PLR-103324-21                                 3

 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.

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
PLR-103324-21                                  4

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.

We also conclude that the termination of Company's S election as a result of Agreement
1 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).

The rulings contained in this letter are 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 request for rulings, it is subject to verification on examination.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

                                       Sincerely,


                                       __________/s/_______________
                                       Laura Fields
                                       Chief, Branch 1
                                       (Passthroughs and Special Industries)
PLR-103324-21                   5

Enclosure:
      Copy for §6110 purposes




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