Unequal liquidation rights received inadvertent S election relief

Plain-English summary

A corporation had voting and nonvoting shares that originally carried identical economic rights. Before its S election, an articles amendment changed the liquidation rights so the nonvoting shares received the remaining assets after both classes reached a specified per-share amount. The board had forgotten about the amendment and the tax advisers were unaware of it, so the resulting second class of stock made the S election ineffective. Legal counsel found the defect during sale due diligence, and the corporation promptly restored identical distribution and liquidation rights. The IRS found the ineffectiveness inadvertent and treated the corporation as an S corporation from the intended election date.

Ruling snapshot

• Question: May the corporation retain S status after an overlooked articles provision created unequal liquidation rights and a second class of stock?
• Outcome: approved, with S status recognized from the intended effective date
• Key authorities: IRC §§ 1361(b)(1) 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: 201935010                                              Third Party Communication: None
Release Date: 8/30/2019                                        Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
                                                               Person To Contact:
---------------------------------------                        -------------------------, ID No. -----------------
---------------------                                          -----------------------------------------------------
-----------------------                                        Telephone Number:
-----------------------------------------------------          ----------------------
                                                               Refer Reply To:
                                                               CC:PSI:B03
                                                               PLR-135954-18
                                                               Date:
                                                               May 23, 2019


LEGEND

X                 =         ---------------------------------------
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A                 =         -------------------------
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B                 =         --------------------------
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State             =        -----------

Date1             =        -----------------------

Date2             =        -----------------------

Date3             =        -------------------

Date4             =        --------------------------

Date5             =        ------------------------

Date6             =        ------------------------

N1                =        --------

N2                =        ----------

N3                =        -----
PLR-135954-18                                  2


Dear --------------------

       This responds to a letter dated December 3, 2018, submitted on behalf of X by
X’s authorized representative, requesting a ruling under §1362(f) of the Internal
Revenue Code (“Code”).

                                           FACTS

       The information submitted states that X was incorporated under the laws of State
on Date1. On Date2, X undertook a recapitalization, and X’s Board of Directors
amended X’s Articles of Incorporation to divide X’s common stock into N1 shares of
class A stock and N2 shares of class B stock. The class A shares retained voting
power and the class B shares held no voting power. The class A and class B shares
otherwise conferred identical rights to distribution and liquidation proceeds. On Date3,
X’s Board of Directors amended X’s Articles of Incorporation for a second time to
change the liquidation rights of X’s stock. After this amendment, the class A and class
B shares were entitled to receive equal shares of any assets of X in liquidation until the
amount of $N3 had been paid to each share. Upon reaching $N3 in liquidation
proceeds per share, the class B shares were entitled to receive the balance of any
remaining assets of X.

       On Date4, X filed an election to be taxed as an S corporation. X represents that
at time this election was filed, X’s Board of Directors were either unaware or had
forgotten that the distribution and liquidation rights had been changed and differed for
class A and class B shares as a result of the Date3 amendment to X’s Articles of
Incorporation. In addition, X represents that X’s tax advisors were unaware of this
amendment. On Date4, X had two shareholders, A and B. A and B remained the only
shareholders of X from Date4 through Date6.

        X represents that X’s legal counsel discovered the Date3 amendments to X’s
Articles of Incorporation that created two classes of stock, in connection with due
diligence performed prior to the sale of X stock by A and B that occurred on Date6.
Upon learning about this Date3 amendment, X’s Board of Directors amended X’s
Articles of Incorporation on Date5 to reconstitute the class A and class B shares into a
single class of stock with identical rights to distribution and liquidation proceeds, in order
to rectify the ineffectiveness of X’s S corporation election.

        X represents that X and X’s shareholders have filed tax returns consistent with X
being an S corporation since Date4. The facts indicate that the circumstances resulting
in the ineffectiveness of X’s S corporation election were inadvertent and were not
motivated by tax avoidance or retroactive tax planning. X and each person who was or
is a shareholder of X at any time since Date4 agree to make any adjustments
PLR-135954-18                                 3

(consistent with the treatment of X as an S corporation) as may be required by the
Secretary with respect to such period.

                                   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 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, the governing provisions).

      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) provides that 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. A termination of an S corporation election under § 1362(d)(2) is effective
on or 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 (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) 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
PLR-135954-18                                4

the ineffectiveness or termination, steps were taken (A) so that the corporation for which
the election was made or the termination occurred is a small business corporation or a
qualified subchapter S subsidiary, as the case may be, or (B) 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 in such corporation at
any time during the period specified pursuant to § 1362(f), agrees to make such
adjustments (consistent with the treatment of such corporation as an S corporation or a
qualified subchapter S subsidiary, as the case may be) 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 or a qualified subchapter S subsidiary, as the case may be during the period
specified by the Secretary.

                                     CONCLUSION

        Based solely on the facts submitted and the representations made, we conclude
that X’s S corporation election was ineffective on Date4 as a result of the second class
of stock created by the Date3 amendment to X’s Articles of Incorporation. We conclude
that this ineffectiveness was inadvertent within the meaning of § 1362(f). Pursuant to
the provisions of § 1362(f), X will be treated as an S corporation beginning on Date4
and continuing thereafter, unless X’s S corporation election otherwise terminated under
§1362(d) for other reasons.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the federal tax consequences of any aspect of any transaction or item
discussed or referenced in this letter. Specifically, no opinion is expressed or implied
regarding X’s eligibility to be an S corporation.

       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 request for a ruling, it is subject to verification on examination.

      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.
PLR-135954-18                                 5

        In accordance with the Power of Attorney on file with this office, copies of this
letter are being sent to your authorized representatives.



                                       Sincerely,



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

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



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