Ineligible shareholders and preferred stock do not end S status

Plain-English summary

An S corporation transferred stock to a corporate creditor, later created preferred stock with different dividend and liquidation rights, and issued preferred shares to two partnerships. The corporation and partnerships were ineligible S corporation shareholders, and the preferred stock created a prohibited second class of stock. The corporation represented that all resulting terminations were inadvertent and not motivated by tax avoidance. The IRS treated the S election as continuing under section 1362(f), conditioned on amending the corporate charter to comply with the one-class rule, moving the shares to eligible shareholders by the specified date, and filing consistent returns.

Ruling snapshot

• Question: Could an S corporation retain its status after stock passed to ineligible corporate and partnership shareholders and a second class of stock was created?
• Outcome: Approved as an inadvertent termination, subject to corrective charter, ownership, and return filings.
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. §§ 1.1361-1(l) and 1.1362-4(d)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201612002                                             Third Party Communication: None
Release Date: 3/18/2016                                       Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.01-04
                                                              Person To Contact:
------------------------------------------                    -----------------------------, ID No. -------------
--------------------------                                    ---------------
------------------------------------------                    Telephone Number:
------------------------------                                ----------------------
                                                              Refer Reply To:
                                                              CC:PSI:01
                                                              PLR-119112-15
                                                              Date:
                                                              December 04, 2015


Legend

X            =     -------------------------------------------------------------------------------------------------
                   ----------------------------------
Y            =     ----------------------------------
State        =     -----------
Date 1       =     --------------------
Date 2       =     ------------------
Date 3       =     ---------------------
Date 4       =     ---------------------
Date 5       =     -------------------
Date 6       =     ---------------------------
P1           =     ----------------------------------------------------
P2           =     -----------------------------------------


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

       This responds to a letter dated June 3, 2015, and subsequent correspondence,
submitted on behalf of X by its authorized representatives, requesting a ruling relating to
X’s status as an S corporation under §§ 1361 and 1362 of the Internal Revenue Code.

                                                     FACTS

        The information submitted states that X was incorporated under the laws of State
on Date 1 and elected to be treated as an S corporation for Federal tax purposes
effective Date 1. On Date 2, shares of X were transferred to Y, a corporation, in
satisfaction of a loan obligation. The transfer of X stock to Y, an ineligible S corporation
shareholder within the meaning of § 1361(b)(1)(B), caused X’s S corporation election to
terminate on Date 2.

PLR-119112-15                                2

        The information submitted states that X filed an Amended and Restated
Certificate of Incorporation on Date 3, which created a new series of X stock that had a
preference as to dividends and liquidation proceeds. As of Date 3, X had issued and
outstanding two classes of stock within the meaning of § 1361(b)(1)(D) and that would
have terminated X’s S corporation election had it not already been terminated.

        On Date 4, in accordance with the terms of a stock purchase agreement, X
transferred shares of X preferred stock to P1 and P2. P1 and P2 are partnerships for
Federal income tax purposes and, thus, are not eligible S corporation shareholders
within the meaning of § 1361(b)(1)(B). The transfer of stock to P1 and P2 on Date 4
would have caused X’s S corporation election to terminate had it not already been
terminated.

       X represents that all circumstances resulting in the termination of X’s S
corporation election were inadvertent and not motivated by tax avoidance. X further
represents that X filed returns consistent with X’s status as an S corporation through tax
period ending Date 5. X and its shareholders agreed to make such adjustments
(consistent with the treatment of X as an S corporation) as may be required by the
Secretary.

                                           LAW

Section 1361(a) 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) 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 § 1362(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.
Differences in voting rights among shares of stock of a corporation are disregarded in
determining whether a corporation has more than one class of stock.

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, by-laws, applicable state law,
and binding agreements relating to distribution and liquidation proceeds (collectively,
the governing provisions). A commercial contractual agreement, such as a lease,

PLR-119112-15                                3

employment agreement, or loan agreement, is not a binding agreement relating to
distribution and liquidation proceeds and thus is not a governing provision unless a
principal purpose of the agreement is to circumvent the one class of stock requirement
of § 1361(b)(1)(D) and § 1.1361-1(l). Although a corporation is not treated as having
more than one class of stock so long as the governing provisions provide for identical
distribution and liquidation rights, any distributions (including actual, constructive, or
deemed distributions) that differ in timing or amount are to be given appropriate tax
effect in accordance with the facts and circumstances.

Section 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361-1(b)(3), (4), and
(5) (relating to restricted stock, deferred compensation plans, and straight debt), in
determining whether all outstanding shares of stock confer identical rights to distribution
and liquidation proceeds, all outstanding shares of stock of a corporation are taken into
account.

Section 1362(a) provides, in part, that 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 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) 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 to obtain shareholder consent, or (B) was terminated under § 1362(d)(2) or
(3), (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 the ineffectiveness or termination,
steps were taken - (A) so that the corporation is a small business corporation, or (B) to
acquire the required shareholder consents, and (4) the corporation, 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 such
ineffectiveness or termination, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that
are appropriate. In general, the adjustments required should be consistent with the
treatment of the corporation as an S corporation during the period specified by the
Commissioner.

                                      CONCLUSION

PLR-119112-15                                4

       Based solely on the facts submitted and representations made, we conclude X’s
S election was terminated and such termination was inadvertent within the meaning of
§ 1362(f). Consequently, we rule that X will be treated as an S corporation from Date 2,
and thereafter, provided X’s S corporation election was valid and was not otherwise
terminated under § 1362(d). X shall file or amend returns for tax periods beginning on
or after Date 2 consistent with this ruling.

       This ruling is contingent upon X filing amended and restated certificate of
incorporation consistent the provisions of § 1361(b)(1)(D) and the transfer of stock held
by Y, P1, and P2 to eligible shareholders by Date 6.

       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. 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.
Pursuant to a power of attorney on file, a copy of this letter is being sent to X’s
authorized representatives.


                                      Sincerely,


                                      David R. Haglund
                                      David R. Haglund
                                      Branch Chief, Branch 1
                                      (Passthroughs & Special Industries)

Enclosures (2)
 Copy of Letter
 Copy for 6110 purposes

cc: