Operating-agreement clause created a second class of stock, but inadvertent-termination relief keeps S status

Plain-English summary

An LLC elected to be taxed as an S corporation, but its operating agreement
contained a liquidation clause that allowed distributions to be made partly
by capital-account balances rather than strictly in proportion to ownership.
An S corporation is allowed only one class of stock, meaning all shares must
confer identical rights to distributions and liquidation proceeds, so that
clause technically created a prohibited second class of stock and terminated
the S election. (The business later reorganized as a corporation in an
F reorganization, with the old entity becoming a qualified subchapter S
subsidiary.) Outside counsel spotted the problem, and the company sought
relief under Section 1362(f), representing that all actual distributions had
been pro rata and no returns were filed inconsistently with S status. The
IRS found the termination inadvertent and ruled the company (and its
successor) continues to be treated as an S corporation from the date of the
defect. Business owners drafting LLC or shareholder agreements care because a
single distribution clause can inadvertently break the one-class-of-stock
rule and jeopardize S corporation treatment.

Ruling snapshot

• Question: Was the S election's termination (an operating-agreement clause creating a second class of stock) inadvertent and curable under § 1362(f)?
• Outcome: Approved (inadvertent termination relief; S status continues for the company and its successor)
• Key authorities: IRC § 1362(f); IRC § 1361(b)(1)(D) (one class of stock); Treas. Reg. §§ 1.1361-1(l), 1.1362-4(b)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201918004 Third Party Communication: None
Release Date: 5/3/2019 Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.04-00
Person To Contact:
---------- ----------, ID No. ----------

---------- Telephone Number:
---------- ----------
Refer Reply To:
CC:PSI:B01
PLR-118651-18

                                                           Date:
                                                           November 15, 2018

LEGEND

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

Y = ----------

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

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

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

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

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

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

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

---

2

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

This letter responds to a letter dated June 5, 2018, submitted on behalf of X (successor
to Y) by X's authorized representative, requesting relief under section 1362(f) of the
Internal Revenue Code (the Code).
FACTS

According to the information submitted, Y was organized as a limited liability company
under the laws of State on Date 1. Subsequently, Y made an election to be treated as
association and an election to be treated as an S corporation effective Date 2.

Y’s shareholders signed an operating agreement, Operating Agreement on Date 3.
Section 10 of Y’s Operating Agreement provided that, “Upon dissolution of the
Company…the proceeds from the liquidation of the Company’s assets shall be
distributed…to the Members in accordance with their respective positive Capital
Account Balances; and, the balance, if any, to the Members, in accordance with their
respective Percentage Interests.”

On Date 4, Y undertook a reorganization under § 368(a)(1)(F), in which Y transferred all
shares of ownership interests into X, a corporation created on Date 4 under the laws of
State. X then filed a Form 8869, Qualified Subchapter S Subsidiary Election, to treat Y
as a qualified subchapter S subsidiary, effective Date 4. Subsequently, X became the
successor to Y for federal income tax purposes. Consistent with Rev. Rul. 2008-18,
2008-1 C.B. 674, X has been treated as the successor S corporation to Y for federal
income tax purposes and therefore did not make a new S corporation election. After the
reorganization, Y filed a Form 8832, Entity Classification Election, to be disregarded as
a separate entity for federal income tax purposes, effective Date 5. Y’s Operating
Agreement was effectively replaced by X’s corporate charter, which X represents
provides for a single class of stock.

While reviewing the reorganization during Year, outside counsel became concerned that
Operating Agreement implemented by Y on Date 3 allowing for disproportionate
distributions to shareholders created a second class of stock.
PLR-118651-18 3

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

                               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 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 1362(d)(2)(A) provides than an election under § 1362(a) shall be 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) further provides that the termination shall be effective
on and after the date of cessation.

Section 1362(f) provides, in relevant part, 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 the ineffectiveness
PLR-118651-18 4

or termination were inadvertent, (3) no later than a reasonable period of time after
discovery of the circumstances resulting in the ineffectiveness or termination, steps
were taken (A) so that the corporation is a small business corporation or (B) to acquire
the shareholder consents, and (4) the corporation and each person who was a
shareholder of 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 the ineffectiveness or
termination, the corporation will be treated as an S corporation during the period
specified by the Secretary.

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 law,
and binding agreements relating to distribution and liquidation proceeds (collectively,
governing provisions).

Section 1.1362-4(b) provides that for purposes of § 1.1362-4(a), the determination of
whether a termination was inadvertent is made by the Commissioner. The corporation
has the burden of establishing that under the relevant facts and circumstances the
Commissioner should determine that the termination was inadvertent. The fact that the
terminating event was not reasonably within the control of the corporation and was not
part of a plan to terminate the election, or the fact that the terminating event or
circumstance took place without the knowledge of the corporation, notwithstanding its
due diligence to safeguard itself against such an event or circumstance, tends to
establish that the termination was inadvertent.
PLR-118651-18 5

                                  CONCLUSION

Based solely on the facts submitted and representations made, we conclude that Y's S
corporation election terminated on Date 3 for having more than one class of stock due
to the provisions in the Operating Agreement. We also conclude that the circumstances
resulting in the termination of Y's S corporation election were inadvertent within the
meaning of § 1362(f). Thus, under the provisions of § 1362(f), Y and its successor, X,
will be treated as an S corporation effective Date 3, and thereafter, provided that Y and
its successor, 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 described above under any other provision of the
Code. In particular, we express or imply no opinion regarding the taxpayer's eligibility to
be an S corporation. In addition, we express or imply no opinion on whether the
conversions on Date 4 qualified as F reorganizations within the meaning of
§ 368(a)(1)(F).

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.
PLR-118651-18 6

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

                                                Sincerely,




                                      By:       David R. Haglund
                                                David R. Haglund
                                                Branch Chief, 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