Preferred-stock terms caused an inadvertent ineffective S election

Plain-English summary

A corporation's charter gave preferred stock priority over its common stock for distributions, creating a prohibited second class of stock when the corporation attempted to elect S status. After discovering the problem, the corporation amended its charter so both classes had identical distribution and liquidation rights, with differences limited to voting and meeting-notice rights. It also represented that all actual distributions had been made pro rata and that it and its shareholders would make any required adjustments. The IRS found the ineffective election inadvertent and treated the corporation as an S corporation from its intended effective date, assuming the election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Was the S election's ineffectiveness due to preferred stock with priority distribution rights inadvertent under § 1362(f)?
• Outcome: approved
• Key authorities: IRC §§ 1361(b) and 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

Number: 201645005                                               Third Party Communication: None
Release Date: 11/4/2016                                         Date of Communication: Not Applicable
Index Numbers:1362.04-00
                                                                Person To Contact:
------------------------------------------------                -----------------------, ID No. -------------------
--------------------------------------------------------        ---------------------------------------------------
-----------------------                                         Telephone Number:
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                                                                Refer Reply To:
                                                                CC:PSI:B3
                                                                PLR-105547-16
                                                                Date:
                                                                August 02, 2016



                                                     Legend

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

n        = --------

m        = ----

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

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

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

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

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

Year     = -------


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

        This letter responds to a letter dated February 10, 2016, submitted on behalf of X
by its authorized representatives, requesting a ruling under § 1362(f) of the Internal
Revenue Code (Code).

                                                      Facts

PLR-105547-16                                2

       The information submitted states that X was incorporated under the laws of State
on Date 1. On Date 2, X filed an amendment to its Certificate of Incorporation,
specifically amending the Fourth Article (“Restated Fourth Article”) to authorize n shares
of Class A Common Stock, all without nominal or par value, and n shares of Preferred
Stock, par value of $m per share, and immediately converted the class of Class B
Common Stock to Preferred Stock. The Restated Fourth Article provided that the
Preferred Stock would receive priority distributions over the Class A Common Stock.

       X elected be classified as an S corporation, effective Date 3. In Year, X became
aware that the Preferred Stock created by the Restated Fourth Article created a second
class of stock that caused X’s S corporation election to be ineffective. On Date 4, X
amended the Restated Fourth Article (“Second Restated Fourth Article”) to provide for n
shares of Class A Common Stock, without par value, and n shares of Class B Common
Stock, without par value, and immediately converted the class of Preferred Stock to
Class B Common Stock. Under the Second Restated Fourth Article, the Class A
Common Stock and the Class B Common Stock confer identical rights to distribution
and liquidation proceeds. The only differences between the classes relate to voting
rights and notice of shareholder meetings.

        X represents that it was not aware that the provisions of the Restated Fourth
Article would render its future S corporation election ineffective. X and its shareholders
agree to make any adjustments that the Commissioner may require, consistent with the
treatment of X as an S corporation. X represents that during all periods since Date 3, X
has made distributions to each shareholder pro rata and has filed all returns consistent
with X’s status as an S corporation.

       X requests a ruling that the ineffectiveness of X’s S corporation election due to
the existence of the Preferred Stock was inadvertent within the meaning of § 1362(f)
and that it will be treated as an S corporation from Date 3 and thereafter.

                                    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.

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        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(d)(2)(B) further provides that the termination shall be
effective on and after the date of cessation.

      Section 1.1361-1(l)(1) of the Income Tax Regulations provides, in part, that a
corporation is generally treated as having only one class of stock if all the 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) 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 the distribution and liquidation
proceeds (collectively, the governing provisions).

       Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a)
by any corporation 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), (2) the Secretary determines that the circumstances resulting in the
ineffectiveness were inadvertent, (3) no later than a reasonable period of time after
discovery of the circumstances resulting in the ineffectiveness, steps were taken so that
the corporation is a small business corporation, 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 this period, then, notwithstanding the circumstances resulting in the
ineffectiveness, the corporation will be treated as an S corporation during the period
specified by the Secretary.

                                        Conclusion

        Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election was ineffective on Date 3 as a result of X having more than
one class of stock. We further conclude that such ineffectiveness was inadvertent
within the meaning of § 1362(f).

       X has taken corrective action so that it meets the requirements of a small
business corporation under § 1361(b). Therefore, we determine that pursuant to the
provisions of § 1362(f), X will be treated as an S corporation effective Date 3 and
thereafter, provided that X’s S corporation election was otherwise valid and has not
otherwise terminated under § 1362(d).

PLR-105547-16                                4

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the facts described above under any other provision of
the Code. In particular, no opinion is expressed as to whether X is otherwise eligible to
be an S corporation.

       This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
of the Code provides that it may not be used or cited for precedent.

       Pursuant to a power of attorney on file, we are sending a copy of this letter to X’s
authorized representatives.

      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 rulings requested, it is subject to verification on
examination.

                                      Sincerely,



                                      Holly Porter
                                      Chief, Branch 3
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)




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