S status preserved after unequal health-plan benefits created second stock class

Plain-English summary

An S corporation allowed nonemployee shareholders, including a trust beneficiary and family members, to participate in its medical and dental plans. They paid the employee portion of the premiums but did not initially reimburse the corporation for the employer portion. The corporation concluded that the binding arrangement permitted disproportionate distributions and therefore created a second class of stock, terminating its S election. It ended the arrangement and the covered family repaid the difference between the employee premium share and the COBRA amount charged to former employees. The IRS treated the termination as inadvertent and allowed the corporation to continue as an S corporation, provided its election was otherwise valid and had not terminated for another reason.

Ruling snapshot

• Question: Could the corporation retain S status after unequal health-plan benefits created a second class of stock?
• Outcome: approved
• Key authorities: IRC §§ 1361(b), 1362(d), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201750007                                              Third Party Communication: None
Release Date: 12/15/2017                                       Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                               Person To Contact:
---------------------                                          -------------------------, ID No. -----------------
------------------------------------------------------------   -----------------------------------------------------
--------------                                                 Telephone Number:
----------------------------------                             ----------------------
----------------------------------                             Refer Reply To:
                                                               CC:PSI:B3
                                                               PLR-109452-17
                                                               Date:
                                                               September 18, 2017




Legend

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

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

D1        = --------------------

D2        = -----------------------

D3        = ------------------

D4        = ----------------------------

Y1        = -------

r         = ------------

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

        This responds to a letter dated March 17, 2017, and subsequent
correspondence, submitted on behalf of X by its authorized representative, 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 D1 and elected to be an S corporation effective D2. Effective D3, X’s Board of
Directors adopted a resolution extending the eligibility to participate in X’s medical and

PLR-109452-17                                2

dental plans to X’s non-employee shareholders, including beneficiaries of trusts owning
X stock, and any spouse or unmarried dependent children of any shareholder or
beneficiary. Thereafter, a non-employee beneficiary of trusts owning X stock and
members of her family participated in X’s medical plan. The beneficiary and her family
timely paid to X the employee share of the premiums determined on the same basis as
X’s employees in the medical plan, but did not reimburse X for the employer share of
the premiums.

       X later consulted with tax advisors about the board resolution, who advised
against this arrangement. X’s Board of Directors resolved to no longer allow non-
employee shareholders to participate in its medical and dental plans, removing them as
of D4. In addition, in Y1, the beneficiary and her family members paid X the difference
between the employee share of the premiums and the COBRA amount charged to
former employees for medical coverage, which totaled $r.

       X represents that the board resolution was a binding agreement under State law
which permitted deemed disproportionate distributions to shareholders and caused X to
have a second class of stock. X represents that the resulting termination of its S
corporation election was inadvertent, and not motivated by tax avoidance or retroactive
tax planning. X and its shareholders have agreed to make any adjustments that the
Commissioner may require, consistent with the treatment of X as an S corporation.

      X requests a ruling that the termination of X's S corporation election was
inadvertent within the meaning of section 1362(f) and that it will be treated as an S
corporation from D3 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) 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 § 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)(1) of the Income Tax Regulations provides, in part, that a
corporation that has more than one class of stock does not qualify as a small business
corporation. Except as provided in § 1.1361-1(l)(4) (relating to instruments, obligations,
or arrangements treated as a second class of stock), a corporation is treated as having
only one class of stock if all outstanding shares of stock of the corporation confer

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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, 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 distribution and liquidation
proceeds (collectively, the governing provisions).

       In §1.1361-1(l)(2)(vi), Example 6 (agreement to adjust distributions for state tax
burdens), S, a corporation, executes a binding agreement with its shareholders to
modify its normal distribution policy by making upward adjustments of its distribution to
those shareholders who bear heavier state tax burdens. The adjustments are based on
a formula that will give the shareholders equal after-tax distributions. The example
states that the binding agreement relates to distribution or liquidation proceeds. The
agreement is thus a governing provision that alters the rights conferred by the
outstanding stock of S to distribution proceeds so that those rights are not identical.
The example concludes that under § 1.1361-1(l)(2)(i), S is treated as having more than
one class of stock.

      Section 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect to be an S corporation.

       Section 1362(d)(2)(A) provides that an election under § 1362(a) will 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 was terminated under § 1362(d)(2); (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 circumstances resulting in such
termination, steps were taken so that the corporation for which the termination occurred
is a small business corporation; and (4) the corporation for which the termination
occurred, and each person who was a shareholder in 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 termination, such corporation shall be treated as an S corporation during the
period specified by the Secretary.

PLR-109452-17                                 4

CONCLUSION

       Based solely on the facts submitted and representations made, we conclude that
X's S corporation election terminated on D3 as a result of X having more than one class
of stock. We further conclude that X's S corporation election was inadvertent within the
meaning of § 1362(f).

       X has taken corrective action so that it once again 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 continuing to be an S corporation from
D3 and thereafter, provided that X's S corporation election was valid and, apart from the
inadvertent termination ruling described above, has not otherwise terminated under
§ 1362(d).

       Except as specifically set forth above, we express or imply no opinion as to 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.

      These rulings are directed only to the taxpayer that requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.

        Pursuant to a power of attorney on file with this office, we will send a copy of this
letter ruling to X's authorized representative.

      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 A. Porter
                                       Chief, Branch 3
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)

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