Corporation keeps S status after correcting a second class of stock

Plain-English summary

A corporation amended its articles to create voting common stock and nonvoting stock entitled to a preferred dividend. That preference created a prohibited second class of stock, so the corporation's S election was ineffective when made. After discovering the problem, the corporation replaced the preferred shares with nonvoting common shares that had no dividend preference. The IRS found the failure inadvertent and ruled that the corporation would be treated as an S corporation from the intended effective date, provided its election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Could the corporation retain S corporation treatment after a dividend preference created a prohibited second class of stock?
• Outcome: approved
• Key authorities: IRC §§ 1361(b) and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201716009 Third Party Communication: None
Release Date: 4/21/2017 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
---------------------------- ------------------------, ID No. ------------------
-------------------------------------- ----------------------------------------------------
---------------------- Telephone Number:
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Refer Reply To:
CC:PSI:B3
PLR-123246-16
Date: January 10, 2017

LEGEND

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

n = -----------

m = -------

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

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

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

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

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

Year = --------

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

  This letter responds to a letter dated July 18, 2016, submitted on behalf of X,

requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

FACTS

  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 Articles of Incorporation, specifically
amending the Article IV ("Restated Article IV") to authorize n shares of Class A Voting
PLR-123246-16 2

Common Stock, par value of $m per share, and n shares of Class B Non-voting
Common Stock, par value of $m per share. Article IV immediately reclassified the
outstanding capital stock as Class A Voting Common Stock and Class B Non-voting
Common Stock. The Restated Article IV also provided that the Class B Non-voting
Common Stock shall have preference in the payment of dividends by the corporation
and the holders thereof shall be entitled to receive from the corporation annually a non-
cumulative dividend equal to five percent of the net “after tax” profits of the corporation.

X elected be classified as an S corporation, effective Date 3. In Year, X became aware
that the Class B Non-voting Common Stock created by the Restated Article IV created a
second class of stock that caused X’s S corporation election to be ineffective. On Date
4, X amended the Articles of Incorporation Article IV to add n shares of Class C Non-
Voting Common stock with no voting rights and no preference in the payment of
dividends. These Class C shares replaced the Class B Non-voting Common Stock.

X represents that the termination of X’s S corporation election was not motivated by tax
avoidance or retroactive tax planning. X and its shareholders have agreed to make any
adjustments consistent with the treatment of X as an S corporation as may be required
by the Commissioner with respect to the period specified by § 1362(f).

X requests a ruling that the ineffectiveness of X's S corporation election due to the
existence of the Preferred Stock (Class B Non-voting Common 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

    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 consents or (B) was terminated under § 1362(d)(2)
or (3), (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 (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 the
ineffectiveness or termination, the corporation will be treated as an S corporation during
the period specified by the Secretary.
PLR-123246-16 3

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).

    Except as specifically ruled above, we express or imply no opinion concerning

the federal tax consequences of the facts of this case under any other provisions of the
Code. Specifically, we express or imply no opinion as to whether X is otherwise eligible
to be treated as an S corporation.

   The ruling contained in this letter is 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)

of the Code provides that it may not be used or cited as precedent.

  In accordance with a power of attorney on file with this office, we are sending a

copy of this letter to your authorized representatives.

                                  Sincerely,



                                  Bradford R Poston
                                  Senior Counsel, Branch 3
                                  Office of Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosures: Copy of this letter
Copy for § 6110 purposes