Invalid S election treated as inadvertent

Plain-English summary

A limited liability company elected corporate and S corporation treatment but failed to obtain all required shareholder consents. Its governing documents also could allow disproportionate distributions, and it later issued units that created a second class of stock. The company amended its operating agreement, redeemed the units, made only pro rata distributions, and reported consistently as an S corporation. The IRS found the ineffective election and potential termination inadvertent and treated the company as an S corporation from the requested effective date, assuming continued eligibility.

Ruling snapshot

• Question: Will the company receive relief for missing consents and potential second-class-of-stock defects?
• Outcome: approved
• Key authorities: IRC §§ 1361(b)(1), 1362(d)(2), 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201650008 Third Party Communication: None
Release Date: 12/9/2016 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
----------------, ID No. ------------------
----------------------------------------------------- Telephone Number:
---------------------------- ----------------------
------------------------- Refer Reply To:
--------------------------------------------------- CC:PSI:B01
PLR-108613-16
Date:
September 01, 2016

LEGEND

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

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

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

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

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

Units = -------------------------------------

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

This responds to a letter dated March 11, 2016, submitted on behalf of X, by X’s
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code.

FACTS

According to the information and representations submitted, X was formed on Date 1 as
a limited lability company under the laws of State. Effective Date 2, X elected to be
treated as an association and made an election to be treated as an S corporation.
PLR-108613-16 2

X’s S corporation election was ineffective because X failed to obtain all required
shareholder consents to the election. Additionally, X’s governing documents could be
interpreted to allow for disproportionate distributions to shareholders, possibly creating a
second class of stock. On Date 3, X and its shareholders amended its governing
documents to remove the provisions allowing for disproportionate distributions.
However, the amendment to the governing documents could be interpreted to continue
to allow for disproportionate distributions. Furthermore, on Date 3, X issued Units,
which constituted a second class of stock. X represents that it has amended its
operating agreement to correct all second class of stock issues and has redeemed the
Units.

X represents that the invalidity of its S election was inadvertent and was not motivated
by tax avoidance or retroactive tax planning. X represents that all of X’s distributions to
shareholders have been pro rata in accordance with their ownership interests. X also
represents that X and its shareholders 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. X and its shareholders represent that
they have filed all returns consistently with X being an S corporation.

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. 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 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 taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

Section 1362(f) provides that if (1) an election under subsection (a) or section
1361(b)(3)(B)(ii) by any corporation (A) was not effective for the taxable year for which
made (determined without regard to subsection (b)(2)) by reason of a failure to meet the
requirements of section 1361(b) or to obtain shareholder consents, or (B) was
terminated under paragraph (2) or (3) of subsection (d) or section 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
PLR-108613-16 3

discovery of the circumstances resulting in such ineffectiveness or termination, steps
were taken (A) so that the corporation for which the election was made or the
termination occurred is a small business corporation or a qualified subchapter S
subsidiary, as the case may be, or (B) to acquire the required shareholder consents;
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 this subsection, agrees to make such adjustments
(consistent with the treatment of such corporation as an S corporation or a qualified
subchapter S subsidiary, as the case may be) 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 or
a qualified subchapter S subsidiary, as the case may be during the period specified by
the Secretary.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S election was ineffective as of Date 2 because of the missing shareholder consents
and possibly because of the disproportionate distribution provisions in the governing
documents. In addition, if X’s S election had been effective as of Date 2, it would have
terminated on Date 3 due to its issuance of Units. It also may have terminated due to
the amended provisions allowing for disproportionate distributions. We further conclude
that the ineffectiveness and potential termination of X’s S corporation election were
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).

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.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.
PLR-108613-16 4

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

                                  Sincerely,


                                  Joy C. Spies
                                  Joy C. Spies
                                  Senior Technician Reviewer, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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

cc: