Inadvertent S corporation termination relief where an LLC operating agreement created a second class of stock

Plain-English summary

An LLC that had elected to be taxed as an S corporation ran into a common trap: 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. When two new members joined, the LLC's operating agreement started allocating profits, losses, and distributions in non-proportional ways tied to capital-account balances, which gave the ownership interests non-identical rights and, technically, created a prohibited second class of stock. That silently terminated the S election. The company later amended the agreement to put everything back on a pro rata basis and asked the IRS for relief under section 1362(f). The IRS ruled the termination was inadvertent and not tax-motivated, so the company will be treated as having remained an S corporation from the termination date forward, provided it is otherwise eligible. The IRS expressed no opinion on whether the company otherwise qualifies as an S corporation.

Ruling snapshot

• Question: Was the termination of an LLC's S corporation election, caused by non-pro-rata allocation and distribution provisions that created a second class of stock, inadvertent under section 1362(f)?
• Outcome: Approved (inadvertent termination relief granted).
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(f); 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: 202310001                                              Third Party Communication: None
 Release Date: 3/10/2023                                        Date of Communication: Not Applicable
 Index Number: 1361.00-00, 1361.01-00,
               1361.01-04, 1362.00-00,                          Person To Contact:
               1362.02-00, 1362.04-00                           --------------------, ID No. -----------------
                                                                Telephone Number:
 --------------------                                           --------------------
 ------------------------------------                           Refer Reply To:
 ------------------------------                                 CC:PSI:B01
 ------------------------------                                 PLR-109737-22
  ------------------------------------------------------        Date:
                                                                November 10, 2022




LEGEND:


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

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

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

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

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

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

Agreement         =        ------------------------------------------------------------------


Amendment =                 -----------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------
                           ------------------------------------------------------------------------------
                           --------------------------------------------


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


This letter responds to a letter dated May 5, 2022, submitted on behalf of X, requesting
a ruling under § 1362(f) of the Internal Revenue Code.

Facts

The information submitted states that X is a limited liability company organized under
the laws of State on Date 1. On Date 1, and until Date 3, only one individual held an
interest in X. On Date 3, two additional individuals acquired interests in X. X made a
timely election to be an S corporation effective Date 2.

On Date 3, the members of X entered into Agreement. Agreement provided that
different types of profits and losses would be allocated in differing percentages, other
than proportionately, including allocations based on any outstanding negative capital
account balances. Agreement also provided that, with respect to certain types of
transactions, distributions would be paid to members in accordance with their respective
positive capital account balances, as adjusted pursuant to section 704 of the Code, and
then would be paid pursuant to differing percentages. Thus, shares of stock of the
corporation could confer non-identical rights to distribution and liquidation proceeds.

Amendment was executed, effective Date 4, to modify the allocation and distribution
language, and to provide for allocations and distributions on a pro rata basis in
accordance with membership ownership percentages.

X represents that the termination of X’s S corporation election was inadvertent and not
motivated by tax avoidance. X further represents that since Date 2, X and its members
have filed all returns consistent with X’s status as an S corporation. X also represents
that since Date 2, all distributions were made to the members based on their pro rata
shares of ownership of X. X and its members have agreed to make such adjustments
consistent with the treatment of X as an S corporation as may be required by the
Secretary.

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 such 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 1362(f) provides 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 to obtain
shareholder consents or (B) was terminated under § 1362(d)(2) or (3), (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 (A) so
that the corporation for which the election was made or the termination occurred is a
small business corporation or (B) to acquire the shareholder consents, 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.

Section 1.1361-1(l)(1) of the Income Tax Regulations provides that a corporation
generally 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 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,
the governing provisions).

Conclusion

Based solely on the facts submitted and representations made, we conclude that X’s S
corporation election terminated on Date 3 due to certain provisions in Agreement.
However, we conclude that such termination was inadvertent within the meaning of
§ 1362(f). Therefore, pursuant to the provisions of § 1362(f), X will be treated as an S
corporation effective Date 3, and thereafter, provided that X is otherwise eligible to be
an S corporation and provided that the election was not otherwise terminated.

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. In particular, no opinion is expressed or implied concerning whether X
otherwise qualifies as 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 the 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.

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,

                                           /s/

                                       Joyce C. Spies
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)


Enclosure (1)


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