Second-class-of-stock defect receives S election relief

Plain-English summary

A corporation made an S election while its stock was subject to an agreement that created a second class of stock, making the election invalid. After discovering the problem, the corporation canceled the agreement and adopted a replacement that did not create a second class. It represented that the defect was inadvertent, was not motivated by tax avoidance or retroactive planning, and that the corporation and shareholders consistently filed as an S corporation and would make required adjustments. The IRS granted inadvertent-invalid-election relief and treated the corporation as an S corporation from its original election date, unless its status was otherwise terminated.

Ruling snapshot

• Question: Could the corporation retain S status after a stock agreement made its original election invalid?
• Outcome: Approved after the defective agreement was replaced.
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(f).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201946013 Third Party Communication: None
Release Date: 11/15/2019 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
--------------, ID No. ----------------
------------------------------ Telephone Number:
---------------------------------- --------------------
--------------------- Refer Reply To:
----------------------------------------- CC:PSI:B01
PLR-135391-18
Date:
July 16, 2019

LEGEND

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

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

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

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

State = ---------

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

This responds to a letter signed December 4, 2018, submitted on behalf of X, by X’s
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code (the Code) for an inadvertent invalid S election.

FACTS

According to the information submitted and representations made within, X was
incorporated on Date 1 under the laws of State and made an S election effective Date 2.

At the time of X’s election, the stock of X was subject to an agreement that X represents
created a second class of stock. Accordingly, X’s S election was invalid.
PLR-135391-18 2

X represents that on Date 3, X cancelled its existing stock agreement and entered into a
new agreement that does not give rise to a second class of stock. X represents that the
ineffectiveness of its S election was inadvertent and was not motivated by tax
avoidance or retroactive tax planning. X also represents that X and its shareholders
agree to make any adjustments required as a condition of obtaining relief under the
inadvertent invalid election rule as provided under § 1362(f) of the Code that may be
required by the Secretary. X and its shareholders represent that they have filed all
returns consistent with X being 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 1 class of stock.

Section 1362(f) provides, in part, that if (1) an election under § 1362(a) by any
corporation was not effective for the taxable year for which made by reason of a failure
to meet the requirements of § 1361(b), (2) the Secretary determines that the
circumstances resulting in the ineffectiveness were inadvertent, (3) no later than a
reasonable period of time after the discovery of the circumstances resulting in the
ineffectiveness, steps were taken so that the corporation for which the election was
made is a small business corporation, and (4) the corporation for which the election was
made, and each person who was a shareholder in such corporation at any time during
the period specified by § 1362(f), 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 ineffectiveness, the corporation is treated as an S corporation 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 invalid because it had a second class of stock. We
further conclude that the invalidity of X’s election was inadvertent within the meaning of
§ 1362(f). Therefore, X will be treated as an S corporation effective Date 2 and
thereafter, provided X’s S corporation election is not otherwise terminated under
§ 1362(d).
PLR-135391-18 3

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 requesting it. Section 6110(k)(3) provides
that it 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,


                                  Faith P. Colson
                                  Faith P. Colson
                                  Senior Counsel, 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