Stock warrant caused at most an inadvertent S election termination

Plain-English summary

An S corporation issued a stock warrant that may have created a prohibited second class of stock and terminated its S election. After discovering the issue, the corporation immediately voided the warrant. Its shareholders later placed the corporation under a new parent in an intended F reorganization, and the parent elected qualified subchapter S subsidiary status for it. The IRS ruled that any S election termination caused by the warrant was inadvertent under section 1362(f). The corporation would be treated as an S corporation through the date it became a QSub, provided no other termination occurred, but the IRS did not rule on the F reorganization or the corporation's other eligibility.

Ruling snapshot

• Question: If the stock warrant created a second class of stock, could the resulting S corporation termination be treated as inadvertent?
• Outcome: Approved.
• Key authorities: IRC §§ 368, 1361, and 1362; Treas. Reg. § 1.1361-1(l)(4)(iii).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201642021 Third Party Communication: None
Release Date: 10/14/2016 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
---------------------------------------- -------------------, ID No. -----------------
-------------------- Telephone Number:
----------------------------- --------------------
------------------------------ Refer Reply To:
CC:PSI:B01
PLR-118723-16
Date:
July 11, 2016

LEGEND

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

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

State A = ------------

State B = -------------

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

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

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

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

Date 5 = --------------------------------

Date 6 = ---------------------------

Dear -----------------

This letter responds to a letter dated June 7, 2016, submitted on behalf of X and Y,
requesting relief under § 1362(f) of the Internal Revenue Code (Code).
PLR-118723-16 2

Facts

According to the information submitted, X was incorporated under the laws of State A
on Date 1 and made an election to be treated as an S corporation effective Date 1. X’s
S election may have terminated effective Date 2 when X issued a warrant on its stock
which may have constituted a second class of stock. X became aware of this problem
on Date 3 and immediately took corrective action, voiding the warrant on Date 4.

On Date 5, incident to what was intended to qualify as a reorganization under
§ 368(a)(1)(F), X’s shareholders contributed all of their stock in X to Y, a corporation
organized under the laws of State A. Effective immediately afterwards, Y made an
election to treat X as a qualified subchapter S subsidiary (QSub). Following the
reorganization, and also on Date 5, X converted into a limited liability company
organized under the laws of State B. On Date 6, Y sold X to an unrelated party.

X and Y represent that the potential termination was not motivated by tax avoidance or
retroactive tax planning. X and Y and its shareholders have agreed to make any
adjustments that the Commissioner may require, consistent with the treatment of X as
an S corporation.

Law

Section 1361(a)(1) defines an “S corporation” as a small business corporation for which
an election under § 1362(a) is in effect for the taxable year.

Section 1361(b)(1) defines a “small business corporation” as a domestic corporation
that is not an ineligible corporation and that 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)(4)(iii) provides that, with certain exceptions, a call option, warrant, or
similar instrument (collectively, call option) issued by a corporation is treated as a
second class of stock of the corporation if, taking in account all the facts and
circumstances, the call option is substantially certain to be exercised (by the holder or a
potential transferee) and has a strike price substantially below the fair market value of
the underlying stock on the date that the call option is issued or at certain other times.

Section 1362(d)(2) 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 a
corporation is an S corporation) such corporation ceases to be a small business
PLR-118723-16 3

corporation. A termination of an S corporation election under § 1362(d)(2) is 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 was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that
the circumstances resulting in such termination were inadvertent, (3) no later than a
reasonable period of time after discovery of the event resulting in the ineffectiveness,
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, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

Conclusion

Based on the information submitted and the representations made, we conclude that
the warrant issued on Date 2 may have caused X to have a second class of stock.
However, we conclude that, if X’s S election was terminated, such termination was
inadvertent within the meaning of § 1362(f) of the Code. Consequently, we rule that X
will be treated as continuing to be an S corporation from Date 2 through Date 5, when X
became a QSub, provided that X’s S election otherwise was not terminated under
§ 1362(d).

Except as specifically ruled upon above, no opinion is expressed as to the federal
income tax consequences of the facts described above under any other provision of the
code. In particular, no opinion is expressed or implied as to whether X otherwise
qualifies as a subchapter S corporation under § 1361. In addition, we express or imply
no opinion on whether the transactions on Date 5 qualified as an F reorganization within
the meaning of § 368(a)(1)(F).

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.
PLR-118723-16 4

In accordance with the Power of Attorney on file with this office, a copy of this letter
ruling will be sent to X and Y’s authorized representatives.

                                   Sincerely,


                                   David R. Haglund
                                   David R. Haglund
                                   Branch Chief, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes

cc: