Corrected non-pro-rata allocations received inadvertent S election termination relief

Plain-English summary

An S corporation amended its operating agreement to permit non-pro-rata allocations, creating a second class of stock and terminating its S election. The corporation later amended the agreement again to require pro rata allocations. It represented that neither it nor its shareholders intended to terminate the election, that they had consistently filed as an S corporation, and that they would make any adjustments required by the IRS. The IRS found the termination inadvertent under IRC § 1362(f) and allowed the corporation to continue to be treated as an S corporation from the termination date forward, provided the election was not otherwise terminated.

Ruling snapshot

• Question: Could the corporation receive inadvertent termination relief after its operating agreement permitted non-pro-rata allocations?
• Outcome: Approved. The corporation continued to be treated as an S corporation after correcting the second-class-of-stock provision.
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201908017 Third Party Communication: None
Release Date: 2/22/2019 Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.02-02,
1361.01-04 Person To Contact:
-------------------, ID No. ------------------
---------------------------- Telephone Number:
----------------------------------- ----------------------
---------------------------------- Refer Reply To:
-------------------------- CC:PSI:B01
PLR-121028-18
Date:
November 14, 2018

LEGEND

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

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

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

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

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

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

This responds to a letter signed June 27, 2018, submitted on behalf of X by X’s
authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code (the Code).

FACTS

According to the information submitted and representations within, X was formed on
Date 1, under the laws of State. Effective Date 2, X elected to be taxed as an S
corporation.

On Date 3, X amended its operating agreement. The amendment provided for
allocations that are not pro rata creating a second class of stock, and, thus, terminated
its S corporation election effective Date 3. X represents that it has taken corrective
PLR-121028-18 2

action and amended the operating agreement to allow for pro rata allocations thus
correcting the second class of stock issue.

X represents that neither X nor its shareholders intended to terminate X’s Subchapter S
election and that X and its shareholders have filed consistently with being an S
corporation. In addition, X represents that, other than the termination due to a second
class of stock, X has qualified as a small business corporation at all times since its
election on Date 2. Lastly, X and its shareholders agree to make any adjustments
required as a condition of obtaining relief under the inadvertent termination rule as
provided under § 1362(f) of the Code as may be required by the Secretary.

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 the year. Section 1361(b)(1) defines a “small business corporation” as a
domestic corporation which is not an ineligible corporation which does not (A) have
more than 100 shareholders, (B) have as a shareholder a person (other than an estate,
and a trust described in subsection (c)(2), or an organization described in subsection
(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D)
have more than 1 class of stock.

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 taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation. Section 1362(d)(2)(B) further provides that the termination shall be effective
on and after the date of cessation.

Treas. Reg. § 1.1361-1(I)(1) provides 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(I)(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 laws, and binding agreements relating to distribution and liquidation
proceeds (collectively, governing provisions). Although a corporation is not treated as
having more than one class of stock so long as the governing provisions provide for
identical distribution and liquidation rights, any distributions (including actual,
constructive, or deemed distributions) that differ in timing and amount are to be given
appropriate tax effect in accordance with the facts and circumstances.

Section 1362(f) provides in part that if (1) an election under § 1362(a) by any
corporation was terminated under § 1362(d), (2) the Secretary determines that the
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circumstances resulting in the termination were inadvertent, (3) no later than a
reasonable period of time after the discovery of the circumstances resulting in the
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 such corporation at any time
during the period of inadvertent termination of the S election, agrees to makes 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 termination, the corporation is treated as an S corporation
during the period specified by the Secretary.

CONCLUSION

Based on the facts submitted and the representations made, we conclude that X’s S
corporation election terminated Date 3, and that the termination was inadvertent within
the meaning of § 1362(f). Therefore, X will be treated as an S corporation effective
Date 3 and thereafter, provided X’s S corporation election is not otherwise terminated
under § 1362(d).

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

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

                                  Sincerely,


                                  Laura C. Fields
                                  Laura C. Fields
                                  Senior Technician Reviewer, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy of this letter for section 6110 purposes