S corporation relief after its operating agreement created a second class of stock

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. Here the company's owners signed an operating agreement whose terms did not match up: distributions were made in proportion to each member's percentage interest, but liquidation proceeds were tied to the relative balances in each member's capital account. That mismatch gave the company a second class of stock and automatically terminated its S election. A later agreement repeated the same defect, and once the owners realized the problem they signed an amended agreement removing it. The company asked the IRS to treat the termination as inadvertent under section 1362(f). The IRS agreed, so the company is treated as continuing to be an S corporation without a break. This matters because a subtle drafting inconsistency between distribution and liquidation provisions can quietly cost a company its S status.

Ruling snapshot

• Question: Was the termination of the company's S election, caused when its operating agreement created a second class of stock, inadvertent under section 1362(f)?
• Outcome: Approved (relief granted; treated as continuing to be an S corporation)
• Key authorities: IRC § 1362(f); § 1362(d)(2); § 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l)(1) and (l)(2)(i)

Full text (IRS public release)

 Internal Revenue Service                                        Department of the Treasury
                                                                 Washington, DC 20224

 Number: 202235003                                               Third Party Communication: None
 Release Date: 9/2/2022                                          Date of Communication: Not Applicable
 Index Number: 1362.04-00
                                                                 Person To Contact:
 ----------------------------------------------------            -------------------, ID No. ---------------
 ------------------------------------------------                Telephone Number:
 -----------------------------------------                       --------------------
 -----------------------------                                   Refer Reply To:
 ---------------------------                                     CC:PSI:B03
                                                                 PLR-124295-21

                                                                 Date:
                                                                 May 27, 2022




LEGEND:

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

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

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

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

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

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

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

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

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

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


Dear --------------:
PLR-124295-21                                2

       This letter responds to a letter dated November 5, 2021, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                         FACTS

        The information submitted states that X was formed on Date 1, under the laws of
State and elected to be classified as an S corporation effective Date 2. Effective Date
3, X’s owners executed Agreement 1. This agreement did not provide for identical
rights to distribution and liquidation proceeds. Specifically, Section 4.2 of Agreement 1
provided that distributions were to be made “in accordance with the Percentage
Interest” of each member, while Section 7.2(b) of Agreement 1 provided that liquidation
proceeds were “to be distributed to the Members pro rata based on the relative credit
balances in each such Member’s Capital Account.” These provisions of Agreement 1
caused X to have more than one class of stock under § 1361(b)(1)(D), and therefore
terminated X’s S election effective Date 3.

       Effective Date 4, X’s owners executed Agreement 2. This agreement also did
not provide for identical rights to distribution and liquidation proceeds. Specifically,
Section 4.2 of Agreement 2 provided that distributions were to be made “in accordance
with the Percentage Interest” of each member, while Section 7.2(b) of Agreement 2
provided that liquidation proceeds were “to be distributed to the Members pro rata
based on the relative credit balances in each such Member’s Capital Account.” X
therefore continued to have more than one class of stock under § 1361(b)(1)(D) after
the execution of Agreement 2. If X’s S election had not terminated upon the execution
of Agreement 1 effective Date 3, it would have terminated effective Date 4 upon the
execution of Agreement 2.

      X represents that on Date 5, soon after it learned that the above provisions
terminated its S corporation election, it executed an amended agreement
(Agreement 3). This agreement eliminated the provisions that caused X to have more
than one class of stock.

       X requests rulings that the termination of its S corporation election on Date 3 was
inadvertent within the meaning of § 1362(f) and that it will be treated as continuing to be
an S corporation on and after Date 3, provided that its S corporation election did not
otherwise terminate. X represents that the circumstances surrounding the termination
of X’s S corporation election were inadvertent and unintended. X further represents that
for each taxable year beginning Date 2, X and its shareholders have filed consistently
with X being an S corporation. In addition, X and its shareholders agree to make any
adjustments that may be required by the Secretary as a condition of obtaining relief
under § 1362(f).


                                  LAW AND ANALYSIS
PLR-124295-21                                 3


        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 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 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 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, 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
PLR-124295-21                                 4

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 circumstances that caused this
termination were inadvertent within the meaning of § 1362(f). Therefore, under
§ 1362(f), X will be treated as continuing to be an S corporation on and after Date 3,
provided that its S corporation election is otherwise valid and has not otherwise
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, we express or imply no opinion on whether X is
otherwise eligible to be an S corporation.

      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 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 X’s authorized representatives.


                                                  Sincerely,


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


Enclosures (2)
      Copy of this letter
      Copy for § 6110 purposes


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