S corporation and QSub receive inadvertent termination relief

Plain-English summary

An LLC taxed as an S corporation acquired another LLC and elected to treat it as a qualified subchapter S subsidiary. The parent's operating agreement still contained partnership provisions that created different liquidation rights, giving it more than one class of stock and terminating the S election while making the QSub election ineffective. After discovering the problem, the company amended the agreement to give members identical distribution and liquidation rights. The IRS found the termination and ineffectiveness inadvertent and allowed the parent and subsidiary to be treated continuously as an S corporation and QSub, subject to their elections otherwise being valid and the parties making any required adjustments.

Ruling snapshot

• Question: Could the parent S corporation and its subsidiary receive relief after partnership provisions created a second class of stock?
• Outcome: Approved as an inadvertent termination and ineffective election under section 1362(f).
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201905002                                              Third Party Communication: None
Release Date: 2/1/2019                                         Date of Communication: Not Applicable
Index Numbers:1361.01-04, 1361.05-00,
              1362.00-00, 1362.01-00,                          Person To Contact:
              1362.01-01, 1362.04-00                           -----------------------, ID No. -------------------
                                                               ---------------------------------------------------
--------------------------------------                         Telephone Number:
-----------------------------------------------                --------------------
-------------------------------------                          Refer Reply To:
------------------------------                                 CC:PSI:B3
                                                               PLR-117171-18
                                                               Date:
                                                               October 23, 2018

                                                     Legend

X                              = ----------------------------------------
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Y                              = -----------------------------------------------------------------
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A                              = --------------------------
---------------------------------------------------------------

B                              =      --------------------------
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State                          =     -----------

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

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

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

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

Operating Agreement =               --------------------------------------------------------------------------------
                                    ---------------------------------------------------------

PLR-117171-18                                2

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

       This letter responds to a letter dated May 11, 2018, 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 organized as a limited liability
company under the laws of State on Date 1. A was the sole shareholder of X on Date

1. X elected to be an S corporation effective Date 2. On Date 3, X acquired from B all
the membership interests of Y, a State limited liability company that made a timely
election to become a qualified subchapter S subsidiary (QSub) of X effective Date 3.
However, on Date 3, X’s Operating Agreement included provisions regarding
partnerships. Section 2.10 of the Operating Agreement provides, in part, that the
members intend that X shall be treated as a partnership for tax purposes and to file its
returns consistent with such treatment. Section 9.3 provides, in part, that if X were to be
liquidated, assets of X are to be distributed to its members in proportion to their
respective positive capital account balances. When X’s members discovered the effect
of the partnership provisions they amended X’s Operating Agreement effective Date 4
to remove the partnership provisions and provide identical distribution and liquidation
rights to X’s members.

        X represents that the termination of X’s S corporation election and
ineffectiveness of Y’s QSub election were inadvertent and not the result of retroactive
tax planning. X further represents that no federal tax return of any person has been
filed inconsistent with a valid S corporation election having been made for X effective
Date 2 and a valid QSub election having been made for Y effective Date 3. X also
represents that all distributions and allocations of income to its shareholders have been
made pro rata in accordance with their interests in X. X, Y, and X’s shareholders have
agreed to make any adjustments required by the Service consistent with the treatment
of X as an S corporation and Y as a QSub.

                                    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) defines a “small business corporation” as a domestic
corporation which does not (A) have more than 100 shareholders, (B) have as a

PLR-117171-18                                 3

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 1361(b)(3)(A) provides that, except as provided in regulations prescribed
by the Secretary, for purposes of this title (i) a corporation which 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, for purposes of § 1361(b)(3)(B), the term
“qualified subchapter S subsidiary” 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 1362(a)(1) 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 1362(d)(2)(A) provides that an election under § 1362(a) is terminated
whenever (at any time on or after the first day of the first 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 any termination under § 1362(d)(2)(A)
is effective on and after the date of cessation.

        Section 1362(f) provides that if (1) an election under § 1362(a) or
§ 1361(b)(3)(B)(ii) by any corporation (i) 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 (ii) was terminated
under § 1362(d)(2) or (3) or § 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 discovery of the circumstances resulting in
such ineffectiveness or termination, steps were taken so that the corporation for which
the election was made or the termination occurred is a small business corporation or a
QSub, as the case may be, or 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 of the corporation at any time during the period specified
pursuant to § 1362(f), agree to make the adjustments (consistent with the treatment of
the corporation as an S corporation or a QSub, as the case may be) as may be required
by the Secretary with respect to this period, then, notwithstanding the circumstances
resulting in such ineffectiveness or termination, the corporation shall be treated as an S
corporation or a QSub, as the case may be, during the period specified by the
Secretary.

PLR-117171-18                                 4

      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).

                                        Conclusion

       Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election terminated on Date 3 and Y’s QSub election was ineffective
on Date 3 because X had more than one class of stock due to the provisions in the
Operating Agreement. We also conclude that the termination of X’s S corporation
election and the ineffectiveness of Y’s QSub election were inadvertent within the
meaning of § 1362(f). Accordingly, under the provisions of § 1362(f), X will be treated
as an S corporation from Date 3 and thereafter, provided that X’s S corporation election
was otherwise valid and not otherwise terminated under § 1362(d). Furthermore, under
§ 1362(f), Y will be treated as a QSub from Date 3, and thereafter, provided the QSub
election for Y is otherwise valid and has not terminated under § 1362(b)(3)(B).

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the facts described above under any other provision of
the Code, including whether X was otherwise a valid S corporation and whether Y was
otherwise a valid QSub.

       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 for precedent.

       Pursuant to a power of attorney on file, we are sending a copy of this letter to X’s
authorized representative.

PLR-117171-18                               5

      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,

                                     Adrienne M. Mikolashek
                                     Chief, Branch 3
                                     Office of the Associate Chief Counsel
                                     (Passthroughs & Special Industries)

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