Partnership-style agreement did not defeat S corporation relief

Plain-English summary

A limited liability company's operating agreement retained partnership-style capital-account, allocation, and liquidation provisions after the company elected S corporation status. Those binding provisions created more than one class of stock and made the S election ineffective. The company represented that it would amend the agreement to give owners equal rights to distributions, dividends, and liquidation proceeds, and all affected shareholders consented to required adjustments. The IRS found the invalid election inadvertent under Section 1362(f) and treated the company as an S corporation from the intended effective date, assuming the election was otherwise valid.

Ruling snapshot

• Question: Could the company receive inadvertent-election relief after its operating agreement created a second class of stock?
• Outcome: Approved, subject to the S election being otherwise valid and not otherwise terminated.
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(f); Treas. Reg. §§ 1.1361-1(l) and 1.1362-4.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201819003 Third Party Communication: None
Release Date: 5/11/2018 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
-------------------------------- -----------------------------, ID No. -------------
---------------------------- -----------------
---------------------------- Telephone Number:
-------------------------------- ----------------------
Refer Reply To:
CC:PSI:01
PLR-124279-17
Date:
February 01, 2018

Legend

X = ------------------------------------------------------------------------------------------
-----------------------------------
State = ---------------------
Date 1 = ----------------------
Date 2 = -----------------------
Date 3 = ----------------------
Agreement = ------------------------------------------------------------------------------------------
------------------------------------------

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

   This letter responds to a letter dated August 4, 2017, and subsequent

correspondence submitted on behalf of X, requesting a ruling under § 1362(f) of the
Internal Revenue Code (Code).

                                                FACTS

   According to the information submitted, X was organized as a limited liability

company under the laws of State on Date 1. Subsequently, X made an election to be
treated as an S corporation effective Date 3.

     Effective Date 2, X’s shareholders signed an operating agreement, Agreement.

Agreement includes provisions in contemplation of X being treated as a partnership for
federal income tax purposes; however, the applicability of those provisions was not
limited to such a situation. At the time of its S corporation election, Agreement included
provisions that cause X to have more than one class of stock. The partnership
provisions include Article 8, relating to capital contributions, capital accounts, and
liability of members. In particular, Article 8(b) provides for the increase, decrease and
maintenance of capital accounts in accordance with § 704 of the Code. Article 10

PLR-124279-17 2

contains the provisions regarding the allocation of profits and losses and distributions to
members. Article 10(a) provides for the allocation of X’s profit and losses in accordance
with member’s vested capital accounts. Article 10(a) further provides the terms and
conditions for X to make liquidating distributions to members with positive vested capital
accounts, in accordance with such positive capital account balances, but only after the
capital accounts have been adjusted to reflect all net profits or losses through the date
of liquidation. Article 10(b) provides for the increase, decrease and maintenance of
capital accounts in accordance with § 1.704-1(b)(2)(iv) of the Income Tax Regulations.
The provisions in Agreement applied during the period when X intended to be treated as
an S corporation, thereby creating the potential for a second class of stock under
§ 1361(b)(1)(D).

    X requests a ruling that if certain provisions of Agreement cause X to have more

than one class of stock for purposes of § 1361(b)(1)(D), then the resulting
ineffectiveness or subsequent termination of X’s S corporation election was inadvertent
within the meaning of § 1362(f). X represents that it will amend the terms of its
operating agreement to provide for equal rights to distributions, dividends, and
liquidation proceeds. In accordance with §§ 1362(f) and 1.1362-4, X and each person
who has been a shareholder of X 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 1361(a) 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.

  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 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).

PLR-124279-17 3

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

    Section 1362(f) provides 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 such
ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of
time after discovery of the circumstances resulting in such 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 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 ineffectiveness or termination, such corporation shall 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 because X had more than one class of stock
due to the partnership provisions in Agreement. We also conclude that the invalidity of
X’s S election, as a result of Agreement creating a second class of stock, was
inadvertent within the meaning of § 1362(f). Accordingly, under the provisions of
§ 1362(f), X will be treated as an S corporation effective on Date 3 and thereafter,
provided that X’s S corporation election was otherwise valid and not otherwise
terminated under § 1362(d).

   Except as expressly provided herein, 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 on whether X was otherwise eligible
to be an S corporation. 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.

PLR-124279-17 4

   This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent. In accordance with the
power of attorney on file with this office, a copy of this letter is being sent to the X’s
authorized representatives.

                                  Sincerely,

                                  Wendy L. Kribell

                                  Wendy L. Kribell
                                  Assistant to the Branch Chief, Branch 1
                                  (Passthroughs & Special Industries)

Enclosures (2)
Copy of Letter
Copy for 6110 purposes

cc: