IRS treats an S corporation's second-class-of-stock termination as inadvertent

Plain-English summary

An S corporation accidentally blew its S election by creating a second class of stock,
then asked the IRS to forgive the slip. To keep S status, a corporation may have only one
class of stock, meaning all shares carry identical rights to distributions and liquidation
proceeds. Here the company amended its charter to authorize a preferred stock with a
15% cumulative dividend and a liquidation preference, then agreed to sell some of it,
which terminated its S election on that date. When it discovered the problem, it rescinded
and canceled the preferred stock retroactively and restored a single class of stock.
Section 1362(f) lets the IRS treat such a termination as inadvertent and restore S status if
the company fixed the problem within a reasonable time and everyone agrees to any
needed adjustments. The IRS found the termination inadvertent and ruled that the
company continues to be treated as an S corporation.

Ruling snapshot

• Question: Was the termination of the company's S election (from creating a second class of stock) inadvertent under § 1362(f)?
• Outcome: Approved (S corporation status preserved)
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d)(2), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

 Internal Revenue Service                               Department of the Treasury
                                                        Washington, DC 20224

 Number: 202215002                                      Third Party Communication: None
 Release Date: 4/15/2022                                Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.04-00
                                                        Person To Contact:
 --------------------------------------------           --------------------------, ID No. ----------------
 ---------------------------                            -----------------
 ------------------                                     Telephone Number:
 -----------------------------                          --------------------
                                                        Refer Reply To:
 ---------------------------------                      CC:PSI:B01
                                                        PLR-114801-21
                                                        Date:
                                                        January 13, 2022




                                                LEGEND

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

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

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

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

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

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


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

       This letter responds to a letter dated July 15, 2021, submitted on behalf of X by
X’s authorized representatives, requesting relief under § 1362(f) of the Internal Revenue
Code (the “Code”).

                                                FACTS

        The information submitted states that X was formed on Date 1 under the laws of
State and elected to be treated as an S corporation effective Date 2. X’s original
Certificate of Incorporation permitted X to issue only one class of stock.

      On Date 3, X modified its original Certificate of Incorporation to permit the
issuance of a second class of stock. The second class of stock was entitled to certain
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distribution and liquidation rights not available to the original class of stock. Specifically,
the modified certificate included the following provisions under Schedule A:

   (1) Section 5.1 provided, in part, “The total number of shares of stock which the
       Corporation shall have authority to issue is forty-five thousand (45,000) shares of
       which (a) forty thousand (40,000) shares are designated as Common Stock
       (“Common Stock”) . . . and (b) five-thousand shares are designated as preferred
       stock (“Preferred Stock”) all of which are designated as Series A Preferred Stock
       (the “Series A Preferred Stock”).”

   (2) Section 5.2 provided, in part, “’Junior Stock’, means, as to the Series A Preferred
       Stock, each other class or series of capital stock . . . which ranks junior to the
       Series A Preferred Stock as to payment of dividends or payment upon a
       liquidation, dissolution or winding up of the Corporation.”

   (3) Section 5.4(a) provided, in part, “The holder of each share of Series A Preferred
       Stock shall be entitled to receive, before any dividends shall be declared and
       paid upon or set aside for the Junior Stock therefore . . . dividends in cash at the
       rate per annum per share equal to fifteen percent (15%) of the Original Purchase
       Price, compounding annually on a cumulative basis.”

   (4) Section 5.4(b) provided, in part, that liquidating payments to a Series A Preferred
       Stock holder “is to be paid in full before any payment shall be made to any
       holders of the applicable Junior Stock thereto.”

       On Date 3, in conjunction with the creation of the preferred stock class, X entered
into an agreement to sell certain units of Preferred Stock to a third-party purchaser.
Thus, X’s S corporation election terminated on Date 3 as a result of X having more than
one class of stock under § 1361(b)(1)(D).

        On or about Date 4, X discovered that its S election was ineffective as a result of
its prior actions. Upon this discovery, X rescinded and canceled the Preferred Stock by
agreement retroactive to Date 3, and further amended its Certificate of Incorporation to
only permit the issuance of one class of stock.

        X represents that the circumstances surrounding the termination of X’s S
corporation election were inadvertent and unintended. X further represents that its
shareholders have filed consistently with X being an S corporation. In addition, X 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) as may be
required by the Secretary.

                                   LAW AND ANALYSIS
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        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 1.1361-1(l)(3) provides, in part, that, in determining whether all
outstanding shares of stock confer identical rights to distribution and liquidation
proceeds, all outstanding shares of stock of a corporation are taken into account. For
example, substantially nonvested stock with respect to which an election under § 83(b)
has been made is taken into account in determining whether a corporation has a
second class of stock, and such stock is not treated as a second class of stock if the
stock confers rights to distribution and liquidation proceeds that are identical, within the
meaning of § 1.1361-1(l)(1), to the rights conferred by the other outstanding shares of
stock.

      Section 1.1362(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 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), (2) the Secretary
determines that the circumstances resulting in the ineffectiveness or termination were
PLR-114801-21                                4

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 solely on the facts submitted and the representations made, we conclude
that X’s S corporation election was terminated on Date 3 as a result of X having more
than one class of stock. We conclude, however, that the termination described was
inadvertent within the meaning of § 1362(f). Therefore, under § 1362(f), X will be
treated as an S corporation effective Date 3 and thereafter, provided that its S
corporation election has not terminated under § 1362(d) other than as discussed in this
letter.

       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. Specifically, no opinion is expressed or implied concerning
whether X otherwise qualifies as an S corporation for federal tax purposes.

       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.

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

                                       Sincerely,



                                    By: _/s/________________________
                                        Laura C. Fields
                                        Branch Chief, Branch 1
                                        Office of the Associate Chief Counsel
                                        (Passthroughs & Special Industries)


 Enclosure (1):
      Copy of this letter for § 6110 purposes




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