IRS grants relief for an inadvertently invalid S corporation election and QSub election

Plain-English summary

An S corporation can have only one class of stock, meaning all shares must confer identical rights to distributions and liquidation proceeds. An LLC that had elected S corporation status adopted an operating agreement written as if it would be taxed as a partnership, allocating liquidation proceeds by capital-account balances. That gave it more than one class of stock, so its S election was never valid, and a later election to treat the LLC as a qualified subchapter S subsidiary (QSub) also failed because the LLC was not a corporation at the time. The taxpayer sought relief under IRC § 1362(f), which lets the IRS forgive an inadvertently invalid or terminated S or QSub election if the defect was not tax-motivated and the parties agree to corrective adjustments. The IRS found both defects inadvertent and granted relief: the LLC is treated as an S corporation for the earlier period and as a QSub for the later period, subject to the usual conditions.

Ruling snapshot

• Question: Were the invalid S corporation election (caused by a second class of stock) and the invalid QSub election inadvertent, so the entity can be treated as an S corporation and QSub for the relevant periods?
• Outcome: Approved (inadvertent-termination relief granted for both elections)
• Key authorities: IRC § 1362(f); § 1361(b)(1)(D), (b)(3); Treas. Reg. §§ 1.1361-1(l), 1.1361-3; Rev. Rul. 2008-18

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202219005 Third Party Communication: None
Release Date: 5/13/2022 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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----------------------------------------------------- Telephone Number:
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---------------------- Refer Reply To:
--------------------------- CC:PSI:B03
PLR-116916-21
Date:
February 03, 2022

LEGEND:

Sub = ---------------------------------------
------------------------

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

State 1 = -------------------

State 2 = -------------

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

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

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

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

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

s = ---

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

  This letter responds to a letter dated August 20, 2021, and subsequent

correspondence, submitted on behalf of X by its authorized representative requesting a
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ruling under § 1362(f) of the Internal Revenue Code (Code).

                                     FACTS

     The information submitted states that Sub, was organized on Date 1 as a limited

liability company under the laws of State 1. Sub elected to be an S corporation effective
Date 2.

   On Date 1, Sub adopted an operating agreement (“Agreement”) that included

provisions in contemplation of Sub being treated as a partnership for Federal income
tax purposes. The partnership provisions applied irrespective of whether X was a
partnership. For instance, sections 7.3 and 10.2 of Agreement provide, in part, that the
proceeds from liquidation will be allocated to member with positive balances in their
respective capital accounts, pro rata, in proportion to the positive balances in those
capital accounts.

   Sub represents that Agreement did not confer identical rights to distribution and

liquidation proceeds and, therefore, Sub had more than one class of stock under
§ 1361(b)(1)(D), causing its S corporation status to terminate. Sub requests relief
pursuant to § 1362(f) due to its governing provisions creating more than one class of
stock.

   The shareholders of Sub formed X, a State 2 corporation, on Date 3. On Date 4,

incident to what X represents was part of a reorganization under § 368(a)(1)(F), Sub
shareholders contributed all the stock in Sub to X, thereby causing Sub to become a
wholly owned subsidiary of X. Consistent with Rev. Rul. 2008-18, 2008-1 C.B. 674, X
would have been treated as the successor S corporation to Sub for federal tax purposes
and therefore would not have had to make a new S corporation election. Since the
original S election for Sub was ineffective, Sub as a limited liability company was by
default classified as a disregarded entity for federal tax purposes instead of as a
corporation. Consequently, X made an S corporation election effective Date 3.

    X filed an election to treat Sub as a qualified subchapter S subsidiary (“QSub”)

effective Date 4. However, X’s election to treat Sub as a QSub was ineffective because
Sub was not a corporation (as defined by § 301.7701-2(b) of the Procedure and
Administration Regulations) on Date 4, and therefore, failed to meet all the requirements
of § 1361(b)(3)(B) at the time the election was made and for all periods for which the
election was to be effective.

  X sold s% interest in Sub to an unrelated buyer on Date 5.

  The information provided also states that for the period that Sub filed as an S

corporation (from Date 2 to Date 4) all ownership units were treated identically with
respect to distribution and liquidation proceeds. Similarly, from Date 2 to Date 4, Sub
represents that Sub and its shareholders have filed tax returns consistent with Sub
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having a valid S corporation election in effect as of Date 2. Since Sub is not
represented to be an S corporation at this time, Sub will not alter its Agreement
provisions.

    X represents that represents that the circumstances which led to the ineffective S

corporation election and ineffective QSub election were inadvertent and not the result of
tax avoidance or retroactive tax planning. The Sub shareholders and Sub agree to
make any adjustments that may be required by the Secretary under 1362(f) consistent
with the treatment of Sub as an S corporation effective Date 2 and later as a QSub
effective Date 4.

                               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 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 1361(b)(3)(A) provides that, except as provided in regulations prescribed

by the Secretary, for purposes of the Code-(i) a corporation which is a QSub shall not
be treated as a separate corporation, and (ii) all assets, liabilities, and items of income,
deduction, and credit of a QSub shall be treated as assets, liabilities, and such items (as
the case may be) of the S corporation.

  Section 1361(b)(3)(B) provides that the term “QSub” means any domestic

corporation which is not an ineligible corporation (as defined in § 1361(b)(2)), if (i) 100
percent of the stock of such corporation is held by the S corporation, and (ii) the S
corporation elects to treat such corporation as a QSub.

   Section 1.1361-1(l)(1) provides, in part, that a corporation that has more than one

class of stock does not qualify as a small business corporation. Except as provided in
§ 1.1361-1(l)(4) (relating to instruments, obligations, or arrangements treated as a
second class of stock), a corporation is 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,
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applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, the governing provisions). Although a corporation is not treated
as having more than one class of stock so long as the governing provisions provide for
identical distribution and liquidation rights, any distributions (including actual,
constructive, or deemed distributions) that differ in timing or amount are to be given
appropriate tax effect in accordance with the facts and circumstances.

    Section 1.1361-3(a)(1) of the Income Tax Regulations provides that the

corporation for which a QSub election is made must meet all the requirements of
§ 1361(b)(3)(B) at the time the election is made and for all periods for which the election
is to be effective.

  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(f) provides, in part, that if (1) an election under § 1362(a) or

§ 1361(b)(3)(B)(ii) 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) or
§ 1361(b)(3)(C), (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 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 or a QSub, as the case may be,
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 or a QSub, as the case may
be) 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 or a QSub, as the case may be, during
the period specified by the Secretary.

                                 CONCLUSION

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

Sub’s S corporation election was ineffective on Date 2 because Sub had more than one
class of stock due to the partnership provisions in Agreement. We conclude, however,
that the circumstances resulting in the termination of X’s S corporation election were
inadvertent within the meaning of § 1362(f). Accordingly, § 1362(f), Sub will be treated
as an S corporation from Date 2 to Date 4 provided that Sub’s S corporation election
was otherwise valid and was not otherwise terminated under § 1362(d).
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   In addition, we conclude that X’s election to treat Sub as a QSub effective Date 4

was ineffective. We also conclude that the circumstances resulting in the
ineffectiveness of the QSub election were inadvertent within the meaning of § 1362(f).
Thus, under the provisions of § 1362(f), Sub will be treated as a QSub from Date 4, to
Date 5 provided that the QSub election was otherwise valid and not otherwise
terminated under § 1361(b)(3)(C).

   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, we express or imply no opinion on whether Sub was
otherwise eligible to be an S corporation and a QSub.

   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 that requested it. Section 6110(k)(3)

provides that this ruling may not be used or cited as precedent.

    Pursuant to a power of attorney on file with this office, we are sending a copy of

this letter to your authorized representative.

                                              Sincerely,



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

Enclosure:
Copy for § 6110 purposes

cc: -----