The IRS grants inadvertent-termination relief so an LLC keeps its S corporation status despite operating-agreement language creating a second class of stock

Plain-English summary

A limited liability company that had elected to be taxed as an S corporation accidentally broke one of the S corporation rules. To stay an S corporation, a company can have only one class of stock, meaning all owners must have identical rights to distributions and liquidation proceeds. This LLC adopted an operating agreement (and then a replacement) with partnership-style provisions, capital accounts, "qualified income offset" language, and liquidating distributions tied to each member's capital account balance, that gave owners non-identical economic rights. That created a prohibited second class of stock and silently terminated the company's S election. Once the company realized the problem, it replaced the operating agreement with a clean version that removed the offending language, and it represented that the lapse was inadvertent and not tax-motivated. Section 1362(f) lets the IRS forgive this kind of accidental termination if the termination was inadvertent, the company fixed it within a reasonable time, and the company and its shareholders agree to any adjustments the IRS requires. The IRS found all conditions met and ruled the company will be treated as continuing to be an S corporation without interruption, as long as its S election was otherwise valid. This is routine but valuable relief: it spares the business the tax consequences of an unintended flip to C corporation status.

Ruling snapshot

• Question: Was the termination of the company's S election (caused by operating-agreement provisions creating a second class of stock) inadvertent, so that relief under § 1362(f) is available?
• Outcome: approved (inadvertent termination; treated as continuing S corporation from the termination date)
• Key authorities: IRC §§ 1362(f), 1362(a), 1362(d)(2)(A), 1361(a)(1), 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l)(1), (l)(2)(i)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202305002 Third Party Communication: None
Release Date: 2/3/2023 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.02-00,
1362.02-02, 1362.04-00 Person To Contact:
----------------------, ID No. -----------------
------------------------------------------- Telephone Number:
---------------- ---------------------
-------------------------------------- Refer Reply To:
------------------------- CC:PSI:B01
--------------------------- PLR-109388-22
Date:
November 04, 2022

Legend

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

State = ---------

Agreement 1 = ----------------------------------------------
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Agreement 2 = ----------------------------------------------
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Agreement 3 = ----------------------------------------------
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Date 1 = -------------------

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

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

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

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

This responds to a letter dated April 20, 2022, submitted on behalf of X by X's
authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code.

                                      Facts

According to the information submitted and representations within, X was formed as a
limited liability company on Date 1 under the laws of State. Effective Date 2, X elected
to be taxed as an S corporation.

Effective Date 3, X adopted an operating agreement, Agreement 1, containing terms
causing X to have more than one class of stock under § 1361(b)(1)(D). Specifically,
section 4.5 of Agreement 1 states that a capital account would be maintained for each
member as provided in Treas. Reg. § 1.704-1(b)(2)(iv); section 5.1 of Agreement 1
states that allocations of items of income, gain, loss, deduction and credit would
generally be allocated based on percentage interests, but also provided for § 704(c) to
be taken into account and for a "qualified income offset"; and section 16.4(d) of
Agreement 1 provides for distributions upon liquidation to be made among the members
in accordance with their positive capital account balances.

Shortly thereafter, X adopted Agreement 2, which replaced Agreement 1, still containing
terms causing X to have more than one class of stock under § 1361(b)(1)(D).
Specifically, section 8.4(c) of Agreement 2 states that the assets would be distributed
among the members in proportion to their capital accounts.

X represents that Agreement 1 and Agreement 2 created a second class of stock,
causing X's S corporation status to terminate. Upon learning that Agreement 1 and then
Agreement 2 terminated X's S election, X replaced Agreement 2 with Agreement 3,
eliminating any language which would create more than one class of stock, effective
Date 4. X represents that the termination of its S election was inadvertent and not
motivated by tax avoidance. X and its shareholders have consented to make any
adjustments as may be required by the Secretary.

X requests relief pursuant to § 1362(f) due to Agreement 1 and Agreement 2 having
governing provisions that created more than one class of stock.

                                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) 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(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, when X adopted Agreement 1, and would have
terminated when X adopted Agreement 2 had it not already terminated on Date 3. We
further conclude that the termination was inadvertent within the meaning of § 1362(f).
Accordingly, under § 1362(f), X will be treated as continuing to be an S corporation on
and after Date 3, provided that X's S corporation election was valid and not otherwise
terminated under § 1362(d).

Except as specifically ruled above, we express or imply no opinion as to the federal
income tax consequences of the facts described above under any other provision of the
Code, including X's eligibility to be a valid S corporation.

Under a power of attorney on file with this office, we are sending a copy of this letter to
your authorized representatives.

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

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.

                                   Sincerely,



                                   ____________________________
                                   Jennifer N. Keeney
                                   Senior Counsel, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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

cc: