Invalid S corporation and QSub elections treated as effective

Plain-English summary

A limited liability company elected S corporation status, but its operating agreement allowed disproportionate liquidation distributions and therefore created a prohibited second class of stock. After an intended F reorganization, a new parent also made a qualified subchapter S subsidiary election for the company, but that election was ineffective because the parent was not a valid S corporation on the effective date. The company amended its operating agreement to remove the defect. The IRS found that both ineffective elections were inadvertent and not motivated by tax avoidance. It treated the company as an S corporation from the original election date and as a valid QSub from the later requested date, provided the elections were otherwise valid and remained in effect.

Ruling snapshot

• Question: Can ineffective S corporation and QSub elections caused by a second class of stock receive inadvertent-election relief?
• Outcome: Approved
• Key authorities: IRC §§ 1361(b), 1362(d), and 1362(f); Treas. Reg. §§ 1.1361-1(l), 1.1361-3, and 1.1361-5

Full text (IRS public release)

 Internal Revenue Service                                     Department of the Treasury
                                                              Washington, DC 20224

 Number: 202315001                                            Third Party Communication: None
 Release Date: 4/14/2023                                      Date of Communication: Not Applicable
 Index Number: 1361.05-00, 1362.00-00,
               1362.02-00, 1362.04-00,                        Person To Contact:
                                                              ----------------------, ID No. -----------------
 -----------------------------                                Telephone Number:
 ----------------------------------------------------------   -------------------
 ------------------------------------------                   Refer Reply To:
 ----------------------------------                           CC:PSI:B3
 -------------------------                                    PLR-113464-22
                                                              Date:
                                                              January 11, 2023



Legend

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

Y          = ------------------------------
------------------------------------

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

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

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

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

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

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




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

       This responds to a letter dated July 12, 2022, and subsequent correspondence,
submitted on behalf of X by X’s authorized representatives, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code).
PLR-113464-22                                 2


                                          FACTS

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

        On Date 3, Y was formed as a corporation under the laws of State 2. On Date 4,
in a transaction intended to qualify as a reorganization under § 368(a)(1)(F), the
members of X transferred their entire interests in X to Y. Y filed Form 8869, Qualified
Subchapter S Subsidiary Election, in which it elected to treat X as a qualified
subchapter S subsidiary (“QSub”) effective Date 4.

        X represents that X’s S corporation election, and X’s QSub election were
ineffective because X had a second class of stock due to X’s operating agreement that
allowed for disproportionate distributions to its members upon dissolution. X represents
that it has amended its operating agreement to correct the operating agreement.

        Y represents that X’s ineffective S corporation election was inadvertent and was
not motivated by tax avoidance. Y also represents that X’s ineffective QSub election
was inadvertent and was not motivated by tax avoidance. Y further represents that X,
Y, and its members agree to make any adjustments required as a condition of obtaining
relief under the inadvertent invalid election rule as provided under § 1362(f) that 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 1
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.
PLR-113464-22                                 3

        Section 1361(b)(3)(B) defines a QSub as a domestic corporation which is not an
ineligible corporation, if 100 percent of the stock of the corporation is held by the S
corporation, and the S corporation elects to treat the corporation as a QSub.

        Section 1.1361-3(a) of the Income Tax Regulations prescribes the time and
manner for making a QSub election. Section 1.1361-3(a)(4) provides that a QSub
election cannot be effective more than two months and 15 days prior to the date of
filing. The proper form for making a QSub election is Form 8869, Qualified Subchapter
S Subsidiary Election.

       Section 1.1361-3(a)(6) provides that an extension of time to make a QSub
election may be available under §§ 301.9100-1 and 301.9100-3.

        Section 1361(b)(3)(D) provides that if a corporation’s status as a QSub
terminates, such corporation (and any successor corporation) shall not be eligible to
make an election under § 1361(b)(3)(B)(ii) to be treated as a QSub before its fifth
taxable year which begins after the first taxable year for which such termination was
effective, unless the Secretary consents to such election.

       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, 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 laws, and binding agreements relating to distribution and liquidation
proceeds (collectively, governing provisions).

        Section 1.1361-5(c)(2) provides, in part, that in the case of a QSub election
effective after December 31, 1996, if a corporation’s QSub election terminates, the
corporation may, without requesting the Commissioner’s consent, have a QSub election
made with respect to it before the expiration of the five-year period described in
§ 1361(b)(3)(D) and § 1.1361-5(c)(1), provided that (i) immediately following the
termination, the corporation is otherwise eligible to have a QSub election made for it;
and (ii) the relevant election is made effective immediately following the termination of
the QSub election.

       Section 1362(d)(2) provides that an S corporation election will 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(f) provides, in part, that if (1) an election under § 1361(b)(3)(B)(ii)
by any corporation (A) was not effective for the taxable year for which made
PLR-113464-22                                4

(determined without regard to § 1361(b)(2)) by reason of a failure to meet the
requirements of § 1361(b) or (B) was terminated under § 1361(b)(3)(C), (2) the
Secretary determines that the circumstances resulting in such ineffectiveness or
termination were inadvertent, (3) no later than a reasonable period of time after
discovery of the circumstances resulting in such ineffectiveness or termination, steps
were taken so that the corporation for which the election was made or the termination
occurred is a QSub, and (4) the corporation for which the election was made or the
termination occurred, and each person who was a shareholder in such corporation at
any time during the period specified pursuant to § 1362(f), agrees to make such
adjustments (consistent with the treatment of such corporation as a QSub) as may be
required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in such ineffectiveness or termination, such corporation shall be
treated as a QSub during 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 ineffective as of Date 2, because X had a second
class of stock. We further conclude that that the ineffectiveness was inadvertent within
the meaning of § 1362(f). Therefore, X will be treated as an S corporation effective
Date 2, and thereafter, provided X’s S corporation election is otherwise valid and is not
otherwise terminated under § 1362(d).

        Additionally, we conclude that the QSub election for X was ineffective because Y
was not a valid S corporation on Date 4. We further conclude that the circumstances
resulting in the ineffective QSub election for X was inadvertent within the meaning of
§ 1362(f). Consequently, under § 1362(f), we rule that, provided the QSub election for
X was otherwise valid and had not otherwise terminated under § 1361(b)(3)(C), X will
be treated as a valid QSub from Date 4, and thereafter.

         Except as specifically ruled upon above, we express or imply no opinion
concerning the federal tax consequences of the facts of this case under any other
provision of the Code. Specifically, we express or imply no opinion regarding X’s
eligibility to be an S corporation, X’s eligibility to be a QSub, or whether the
reorganization qualified as a reorganization under § 368(a)(1)(F).

       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 who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.
PLR-113464-22                                 5

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

                                      Sincerely,




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



Enclosure:
      Copy of this letter for § 6110 purposes




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