S status restored after operating agreement created second stock class

Plain-English summary

An LLC had elected S corporation status, but its operating agreement retained partnership provisions and authorized profits interests with different liquidation rights. Issuing those interests caused the company to have more than one class of stock and terminated its S election. After discovering the problem, the company canceled the profits interests, amended the agreement to provide identical distribution and liquidation rights, and later merged into another entity. Because returns, distributions, and income allocations had consistently treated the company as an S corporation and the defect was inadvertent, the IRS restored S status for the affected period.

Ruling snapshot

• Question: Did the second class of stock cause an inadvertent S election termination eligible for relief?
• Outcome: Approved; the company was treated as an S corporation throughout the specified pre-merger period.
• 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: 201949009 Third Party Communication: None
Release Date: 12/6/2019 Date of Communication: Not Applicable
Index Numbers:1362.00-00, 1362.02-00,
1362.04-00, 1361.00-00, Person To Contact:
1361.01-00, 1361.01-04 -----------------------, ID No. -------------------
---------------------------------------------------
------------------------------------------------ Telephone Number:
------------------------------------------------------------ --------------------

• Refer Reply To:
  ---------------------- CC:PSI:B3
  ------------------------------ PLR-110260-19
  Date:
  September 09, 2019

                                                Legend
  

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

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

A = --------------------

B = ---------------------

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

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

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

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

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

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

Date 6 = ------------------

Date 7 = ------------------
PLR-110260-19 2

Date 8 = -----------------------------

Date 9 = ----------------------------

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

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

    This letter responds to a letter dated April 17, 2019, 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 and B were the members of X on Date

1. X elected to be an S corporation effective Date 2. On Date 3, X’s Operating
   Agreement included provisions regarding partnerships. Section 4(j) of the Operating
   Agreement provides, in part, that it is intended that X will be treated as a partnership for
   federal income tax purposes and that each Member will be treated as a partner of a
   partnership for tax purposes. Section 4(a) provides, in part, that X shall have two (2)
   classes of Units: Class A Units and Profits Units. Sections, 4, 8, and 19 of the Operating
   Agreement state that a Profits Interest only shares in liquidation proceeds due to profits
   earned after the issuance of the Profit Unit. On Date 4 and Date 5, X issued Profits
   Interests.

   When X’s shareholders discovered the effect of the partnership provisions and
   the issuance of the Profits Interests, X canceled the Profits Interests between Date 6
   and Date 7. X amended its operating agreement on Date 8 to remove the partnership
   provisions and the Profits Interest provisions and to provide identical distribution and
   liquidation rights to X’s shareholders. On Date 9, X merged into Y, with Y surviving the
   merger, in a transaction intending to qualify as a reorganization described in
   § 368(a)(1)(F), in accordance with Income Tax Regulation §§ 1.368-2(m)(3)(i) and
   1.368-2(m)(4).

   X represents that the termination of X’s S corporation election was 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. 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 and X’s shareholders have agreed to make any adjustments
   required by the Service consistent with the treatment of X as an S corporation.
   PLR-110260-19 3

                               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
   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(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-110260-19 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 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 was 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 until Date 9, provided that X’s S corporation election was otherwise valid
   and not otherwise terminated under § 1362(d).

   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. We also express no
   opinion on whether X’s merger into Y qualifies as a § 368(a)(1)(F) reorganization.

   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-110260-19 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,
   
                                Richard T. Probst
                                Senior Technician Reviewer, Branch 3
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)
   

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

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