Grants conditional relief for ineffective S corporation and QSub elections

Plain-English summary

A limited liability company attempted to elect S corporation status while one owner was an ineligible shareholder. Its operating agreement also contained partnership-style provisions that created a potential second class of stock. The company later acquired a subsidiary and requested a QSub election effective on the acquisition date, even though the election could not take effect until the following day. The IRS found the ineffective S corporation and QSub elections inadvertent under section 1362(f). It allowed the company to be treated as an S corporation and the subsidiary as a QSub, conditioned on filing completed election forms within 120 days using the permitted effective dates.

Ruling snapshot

• Question: Could the company obtain relief for an S election invalidated by an ineligible shareholder and a second class of stock, along with an incorrectly dated QSub election?
• Outcome: Approved, conditioned on filing Forms 2553 and 8869 within 120 days.
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. §§ 1.1361-1, 1.1361-3, 1.1361-4, and 1.1362-4.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201815003 Third Party Communication: None
Release Date: 4/13/2018 Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-02,
1361.01-04, 1361.05-00, Person To Contact:
1362.00-00, 1362.01-00, ------------------------, ID No. ------------------
1362.01-01 ----------------------------------------------------
Telephone Number:
----------------------------------------------- ----------------------
------------------------------------- Refer Reply To:
--------------------------------- CC:PSI:03
---------------------------------------- PLR-121635-17
Date:
December 29, 2017

Legend

Company = -------------------------------------------------

A = ---------------------------

                                ----------------------------

B = -----------------------------

C = ----------------------

D = ----------------------

E = ----------------------

Agreement 1 = ---------------------------------------------------------------------------------
--------------------------------------

Agreement 2 = ---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
-----------------------------

Sub = --------------------------------------

HoldCo Sub = -----------------------------------------

State 1 = --------------

State 2 = -----------

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

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

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

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

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

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

Date 7 = ----------------------

Date 8 = -------------------

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

This letter responds to a letter dated July 12, 2017, and subsequent correspondence,
submitted on behalf of Company by its authorized representative requesting a ruling
under § 1362(f) of the Internal Revenue Code (Code).

                                                  Facts

The information submitted states Company was organized on Date 1 as a limited
liability company under the laws of State 1. On Date 2, A, B, C, and D (the Company
Shareholders) filed Form 2553, Election by a Small Business Corporation, for Company
to be an association treated as an S corporation effective Date 3. As of Date 3, B was
an ineligible shareholder under § 1361(b)(1)(B). It was the intent of the Company
Shareholders that before Date 3 the Company shares held by B would be transferred to
E, an eligible S corporation shareholder.

Effective on Date 1, the Company Shareholders signed an operating agreement,
Agreement 1. Agreement 1 included provisions in contemplation of Company being
treated as a partnership for federal income tax purposes; however, the applicability of
those provisions was not limited to such a situation. Agreement 1 included the following
partnership provisions: (1) Article 2.3 providing, in part, “[t]he Managers shall provide to
the Members, in the time, manner, and form that the Managers determine, reports
concerning the financial condition and results of operation of the Company and the
Members’ Capital Accounts;” (2) Article 3.5 providing for the increase, decrease,
maintenance and transfer of capital accounts in accordance with § 1.704-1(b)(2)(iv) of
the Income Tax Regulations; (3) Article 4.1 providing “the Company’s net profits, net
losses, and other items of income, gain, loss, deduction and credit shall be allocated
among the Members first, so their Capital Account balances are, as nearly as possible,
in the same ratios as their respective Shares, and then, pro rata, in accordance with the
Shares held by each member,” and requiring certain adjustments under § 704(b) to
ensure that the allocation of profits and losses have substantial economic effect; (4)
Article 4.2 providing the terms and conditions for the Company to make distributions to
its members, including that “[n]o distribution can be made until all debts to any member
is paid in full with all accrued interest;” and (5) Article 9.3, in part, required “liquidating
distributions to Members who have positive Capital Accounts, in accordance with such
positive Capital Account balances, but only after the Capital Accounts have been
adjusted for all prior contributions and distributions and allocations … for all periods.”
These provisions applied during the period when Company intended to be treated as an
S corporation until Date 4, when Agreement 2 replaced Agreement 1 in order to
eliminate the potential for a second class of stock under § 1361(b)(1)(D).

Sub was organized on Date 5 as a corporation under the laws of State 2. On Date 6
Company purchased all of the shares of Sub in a qualifying stock purchase for which a
§ 338(h)(10) election was made. Company then made an election on Form 8869,
Qualified Subchapter S Subsidiary Election, to treat Sub as a QSub pursuant to
§ 1361(b)(3)(B)(ii) effective Date 6. On Date 8 Company transferred the stock of Sub to
HoldCo Sub, a wholly owned disregarded entity owned by Company.

Company requests four rulings. First, the ineffectiveness of the Company’s S election
caused by B being a member on Date 3, was inadvertent within the meaning of §
1362(f) and Company will be treated as an S corporation from Date 2 and thereafter.
Second, the ineffectiveness or termination of the Company’s S election due to the
provisions of Agreement 1 was inadvertent within the meaning of § 1362(f), and
Company will be treated as an S corporation from Date 2 and thereafter. Third, the
ineffectiveness or termination of Sub’s QSub election caused by the ineffectiveness or
termination of the Company’s S election was inadvertent within the meaning of
§ 1362(f). Fourth, Company’s request for an effective date for Sub’s QSub election of
Date 6, rather than Date 7, was inadvertent within the meaning of § 1362(f), and
Company’s QSub election for Sub will be treated as effective Date 7.

In accordance with §§ 1362(f) and 1.1362-4, Company and each person who has been
a shareholder of Company at any time on or after Date 3 through the date of the ruling
request have consented to any adjustments as may be required by the Secretary.

                                 Law and Analysis

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

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.

An S corporation election is not effective if there is an ineligible shareholder at any time
during the taxable year for which the election is to be effective. See
§ 1.1362-6(a)(2)(iii), Example 3.

A shareholder who disposes of stock in an S corporation is treated as the shareholder
for the day of the disposition. See § 1.1377-1(a)(2)(ii).

Section 1.1361-1(l)(1) provides, in part, that a corporation is generally treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds.

Section 1.1361-1(l)(2)(i) provides 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 laws,
and binding agreements relating to distribution and liquidation proceeds (collectively,
governing provisions).

Section 1361(b)(3)(A) provides that, except as provided in regulations prescribed by the
Secretary, for purposes of the Code (i) a corporation that is a QSub shall not be treated
as a separate corporation, and (ii) all assets, liabilities, and items of income, deduction,
and credit of a QSub shall be treated as assets, liabilities, and such items (as the case
may be) of the S corporation.

Section 1361(b)(3)(B) provides that the term “QSub” means any domestic corporation
which is not an ineligible corporation (as defined in § 1361(b)(2)), if (i) 100 percent of
the stock of such corporation is held by the S corporation, and (ii) the S corporation
elects to treat such corporation as a QSub.

Section 1.1361-3(a)(1) provides that the corporation for which a QSub election is made
must meet all the requirements of § 1361(b)(3)(B) at the time the election is made and
for all periods for which the election is to be effective.

When an S corporation that acquires another S corporation in a qualified stock
purchase for which a § 338(h)(10) election is made and then makes a QSub election,
the QSub election for the acquired subsidiary may not be effective until the day after the
acquisition date. See § 1.1361-4(d), Example (3).

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(f) and the regulations thereunder provide relief for an ineffective S
corporation election or ineffective QSub election (i.e., treating the ineffective election as
effective) or inadvertent termination of an S corporation election or QSub election
provided the following conditions are met:

a. The corporation made an election under § 1362(a) or § 1361(b)(3)(B)(ii) that was
ineffective or was terminated;

b. The Service determines that circumstances resulting in the ineffectiveness or
termination were inadvertent;

c. Steps were taken by the corporation to qualify it as a small business corporation
or QSub within a reasonable period of time after discovery of the termination
event; and

d. The corporation and all shareholders agree to any adjustments that the Service
may require for the period.

                                     Conclusion

Based on the facts submitted and representations made, we conclude that the S
election filed on Date 3 and the QSub election intended to be effective on Date 6 were
ineffective. The S election for Company was ineffective because on Date 3 B held
Company shares, signed and submitted Form 2553 electing S status for Company, and
was an ineligible S corporation shareholder under § 1361(b)(1)(B). In addition,
Company’s S election was ineffective because Company had more than one class of
stock due to the partnership provisions in Agreement 1. The QSub election for Sub was
ineffective because it was effective on Date 6 and Company was not an S corporation at
the time of the election.

We conclude the ineffectiveness of the S election for Company and of Company’s QSub
election for Sub were inadvertent within the meaning of § 1362(f). We also conclude
that the ineffectiveness of Company’s S election, as a result of Agreement 1 creating a
second class of stock, was inadvertent within the meaning of § 1362(f). Accordingly,
under § 1362(f), Company will be treated as an S corporation from Date 3, and
thereafter, provided the S election for Company is otherwise valid and has not
terminated under § 1362(d). Furthermore, under § 1362(f), Sub will be treated as a
QSub from Date 7, and thereafter, provided the QSub election for Sub is otherwise valid
and has not otherwise terminated under § 1361(b)(3)(B). Such relief is conditioned
upon filing a completed Form 2553 and Form 8869 to make an S election for Company
and QSub election for Sub, respectively, with the appropriate service centers within 120
days of the date of this letter to be effective Date 3 for the S election and Date 7 for the
QSub election. A copy of this letter should be attached to the submitted Form 2553 and
Form 8869.

Except as specifically ruled upon 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, we express or imply no opinion regarding whether Agreement 2
creates a second class of stock.

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

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.

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

                                  Sincerely,


                                  ______________________________
                                  Bradford R. Poston
                                  Special Counsel to the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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

cc: