IRS treats an LLC's back-to-back second-class-of-stock terminations as inadvertent

Plain-English summary

An LLC that had elected to be taxed as an S corporation lost its S status because a series
of operating agreements gave its members different rights to distributions and liquidation
proceeds, which counts as a prohibited second class of stock. One agreement required
capital-account maintenance and priority return of contributions; later agreements let a
departing member trade his interest for a percentage-of-sale "transaction bonus" plus
monthly consulting pay, again creating unequal rights. The company fixed this by adopting
a restated operating agreement with equal distribution and liquidation rights, filing an
amended return, and making true-up distributions. Section 1362(f) lets the IRS restore S
status when a termination was inadvertent, the company corrected it within a reasonable
time, and the owners agree to any needed adjustments. The IRS found both terminations
inadvertent and ruled the company continues to be treated as an S corporation.

Ruling snapshot

• Question: Were the company's S-election terminations (from operating agreements 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: 202215003                                             Third Party Communication: None
Release Date: 4/15/2022                                       Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.02-00,
              1362.04-00                                      Person To Contact:
                                                              ---------------------------, ID No. ---------------
----------------                                              -----------------
--------------------------------------                        Telephone Number:
----------------------------                                  --------------------
---------------------------------------                       Refer Reply To:
                                                              CC:PSI:01
                                                              PLR-114908-21
                                                              Date:
                                                              January 14, 2022
         Legend:




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

A               =        ------------------
                         -------------------------

B               =        ------------
                         -------------------------

C               =        --------------------
                         -------------------------

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

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

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

Agreement 4 =            -----------------------------------------------

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

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

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

Date 4          =        -------------------------
PLR-114908-21                                2

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

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

n%              =      ----


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

This letter responds to a letter dated June 29, 2021, 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 organized on Date 1 as a limited liability
company under the laws of State. A, B, and C were the sole members of X.

Effective Date 2, X filed Form 2553, Election by a Small Business Corporation, for X to
be treated as an S corporation. At the time of the election, A, B, and C had an oral
operating agreement, Agreement 1.

The provisions of Agreement 1 applied until Date 3, when Agreement 2, Agreement 3
and Agreement 4 replaced Agreement 1. The provisions of Agreement 2, Agreement 3,
and Agreement 4 entitled A, B, and C to different rights concerning distributions and
liquidation proceeds, and thus created a second class of stock. Specifically, Section 6.2
of Agreement 2 required X to maintain capital accounts and provided that capital
accounts would control the division of assets on liquidation. Section 11.2 of Agreement
2 provided that distributions would be made first to each person owning a transferable
interest that reflects contributions made and not previously returned in an amount equal
to the unreturned contributions, and thereafter to members in the proportions in which
they shared in distributions before dissolution.

The provisions of Agreement 2 applied from Date 3, and Agreement 3 and Agreement 4
applied from Date 4, during the period when X intended to be treated as an S
corporation, until Date 5. Pursuant to Agreement 3 and Agreement 4, C gave up his
ownership interest in X for a “transaction bonus” equal to n% of the net cash proceeds
from a subsequent sale of X, plus a payment of $1,000 per month for occasional
consulting services. X represents that, in substance, Agreement 3 and Agreement 4 are
appropriately characterized as an exchange of C’s ownership interest in X for a
continuing ownership interest that conferred rights to distribution and liquidation
proceeds different from those held by A and B. Thus, Agreement 3 and Agreement 4
created a second class of stock.
PLR-114908-21                                3

X represents that the following corrective action was taken: on Date 5, A, B, and C
executed an amended and restated operating agreement for X, X filed an amended
return to reflect the amended and restated operating agreement, and X made “true-up”
distributions to A, B, and C. The amended and restated operating agreement did not
include capital account maintenance provisions and required that all distribution and
liquidation proceeds be shared in accordance with the shareholders’ ownership
interests. Additionally, Agreement 3 and Agreement 4 were terminated as of Date 5.

X requests two rulings. First, due to the provisions of Agreement 2, X's S election was
inadvertently terminated within the meaning of § 1362(f), and X will be treated as an S
corporation from Date 3 and thereafter. Second, the termination of X's S election due to
the provisions of Agreement 3 and Agreement 4 was inadvertent within the meaning of
§ 1362(f), and X will be treated as an S corporation from Date 4 and thereafter.

X represents that the termination of its S election was inadvertent and was not
motivated by tax avoidance or retroactive tax planning. X also represents that X and its
shareholders agree to make any adjustments required as a condition of obtaining relief
under the inadvertent invalid election rule as provided under § 1362(f) of the Code that
may be required by the Secretary. X and its shareholders represent that they have filed
all returns consistent with X 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) 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,
PLR-114908-21                                4

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(f) and the regulations thereunder provide relief for an ineffective S
corporation election (i.e., treating the ineffective election as effective) or inadvertent
termination of an S corporation election provided the following conditions are met: (A)
The corporation made an election under § 1362(a) that was ineffective or was
terminated; (B) The Service determines that the circumstances resulting in the
ineffectiveness or termination were inadvertent; (C) Steps were taken by the corporation
to qualify it as a small business corporation within a reasonable period of time after
discovery of the ineffectiveness or termination event; and (D) The corporation and all
shareholders agree to any adjustments that the Service may require for the period.

CONCLUSION

Based on the facts submitted and representations made, we conclude that X’s S
election terminated on Date 3 because Agreement 2 created a second class of stock.
We further conclude that the termination was inadvertent within the meaning of
§ 1362(f). We also conclude that, if X’s S election had not terminated on Date 3, it would
have terminated on Date 4 as a result of Agreement 3 and Agreement 4 creating a
second class of stock. We further conclude that this termination would have been
inadvertent. Accordingly, under § 1362(f), X will be treated as an S corporation from
Date 3, and thereafter, provided the S election for X otherwise is valid and has not
terminated under § 1362(d).

Except as specifically ruled above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provisions of
the Code. Specifically, we express or imply no opinion as to whether X was otherwise
eligible to be treated 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-114908-21                                 5

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

In accordance with a power of
attorney on file with this office, we are sending a copy of this letter to X's authorized
representatives.

                                       Sincerely,


                                       ___________/s/______________
                                       Joy C. Spies
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs and Special Industries)

Enclosure:
      Copy of this letter for § 6110 purposes



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