Second class of stock caused an inadvertent invalid S election

Plain-English summary

An LLC elected corporate and S corporation treatment, but its operating agreement allowed non-pro rata contributions, special allocations and distributions, and liquidation distributions based on capital accounts. Those provisions created nonidentical distribution and liquidation rights and therefore more than one class of stock, making the S election invalid. The company also made disproportionate distributions. After discovering the problem, it amended the agreement to remove the offending provisions and made corrective distributions so that distributions and income allocations were pro rata. The IRS found the invalid election inadvertent and treated the company as an S corporation from the election’s original effective date, provided the election was otherwise valid and did not otherwise terminate.

Ruling snapshot

• Question: Could the company receive inadvertent-election relief after its operating agreement created a second class of stock?
• Outcome: Approved; the company is treated as an S corporation from the original election date
• Key authorities: IRC §§ 1361(b), 1362(d), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202511002 Third Party Communication: None
Release Date: 3/14/2025 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
---------------------------------------------- -------------------, ID No. ---------------
------------------------------------------------ Telephone Number:
--------------------- --------------------
-------------------------- Refer Reply To:
--------------------------- CC:PSI:B03
PLR-102905-23
Date:
December 17, 2024

LEGEND:

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

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

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

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

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

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

Year 1 = -------

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

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

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

   This letter responds to a letter dated January 4, 2023, and subsequent

correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code (Code).
PLR-102905-23 2

                                       FACTS

     The information submitted states that X was formed on Date 1 as a limited

liability company under the laws of State. X’s owners executed its operating agreement
(Agreement 1) effective Date 2. X made an election to be classified as an association
taxable as a corporation as well as an election to be classified as an S corporation by
filing Form 8832, Entity Classification Election, and Form 2553, Election by a Small
Business Corporation, both effective Date 3.

    Agreement 1 did not provide for identical rights to distribution and liquidation

proceeds. Specifically, Section 4 of Agreement 1 provided that X’s owners may make
non-pro rata contributions, and that such contributions would increase the contributing
owners’ capital accounts. Additionally, Section 5 provided that X could make special
allocations to its owners and that X could make distributions that were not in proportion
to its owners’ proportional ownership interests. Finally, Section 8.4 of Agreement 1
provided that, upon dissolution, X would distribute its remaining assets to its owners in
proportion to their positive capital account balances. Taxpayer represents that these
provisions of Agreement 1 caused X to have more than one class of stock under
§ 1361(b)(1)(D), and therefore rendered X’s S election effective Date 3 invalid.
Separately, X also made disproportionate distributions to certain owners between Date
3 and Date 4.

    X represents that on or about Date 4, soon after it learned that the above

provisions terminated its S corporation election, it executed an amended operating
agreement (Agreement 2). This agreement eliminated the provisions that caused X to
have more than one class of stock. X also represents that it has made corrective
distributions so that all distributions and allocations of income have been made pro rata.

   X requests a ruling that the invalidity of its initial S corporation election effective

Date 3 was inadvertent within the meaning of § 1362(f) and that it will be treated as an
S corporation beginning on Date 3 and thereafter, provided that its S corporation
election did not otherwise terminate. X represents that the circumstances surrounding
the invalidity of X’s initial S corporation election were inadvertent and not the result of
tax avoidance or retroactive tax planning. X further represents that for each taxable
year beginning Date 3, 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

    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.
PLR-102905-23 3

   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
the period specified by the Secretary.
PLR-102905-23 4

                                  CONCLUSION

   Based solely on the facts submitted and the representations made, we conclude

that X’s initial S corporation election effective Date 3 was invalid because of X having
more than one class of stock. We conclude, however, that the circumstances that
caused this S election to be invalid were inadvertent within the meaning of § 1362(f).
Therefore, under § 1362(f), X will be treated as being an S corporation on and after
Date 3, provided that its S corporation election was 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 was or
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

cc: -