IRS grants S corporation relief for partnership terms and IRA ownership

Plain-English summary

A limited liability company intended to be taxed as an S corporation, but its operating agreement contained partnership-style allocation and liquidation provisions that created a second class of stock. An individual retirement account, which generally cannot own S corporation stock, also held a membership interest for a period before the company repurchased it. The company replaced its operating agreement, removed the IRA as an owner, filed returns consistently with S status, and obtained shareholder consent to any required adjustments. The IRS treated both the ineffective election caused by the second class of stock and the termination caused by the IRA ownership as inadvertent under section 1362(f). Relief was conditioned on adopting the submitted operating-agreement revisions within 120 days and applying specified shareholder treatment to gains and losses during the IRA's ownership period.

Ruling snapshot

• Question: May the company retain S corporation treatment despite governing provisions creating a second class of stock and temporary ownership by an IRA?
• Outcome: approved
• Key authorities: IRC §§ 1361(b)(1), 1362(a), 1362(d), and 1362(f); Treas. Reg. §§ 1.1361-1 and 1.1362-4

Full text (IRS public release)

Internal Revenue Service                                          Department of the Treasury
                                                                  Washington, DC 20224

Number: 202010001                                                 Third Party Communication: None
Release Date: 3/6/2020                                            Date of Communication: Not Applicable
Index Numbers: 1361.01-02, 1361.01-04,
              1362.00-00, 1362.01-00,                             Person To Contact:
              1362.04-00                                          -----------------------, ID No. -------------------
                                                                  ---------------------------------------------------
-----------------                                                 Telephone Number:
---------------------------------                                 --------------------
--------------------------------------------------                Refer Reply To:
--------------------------                                        CC:PSI:03
                                                                  PLR-113034-19
                                                                  Date:
                                                                  November 29, 2019



Legend

Company                    =         -------------------
------------------------------------------------------------

State                      =        ---------

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

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

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

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

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

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

Agreement 1                =        ----------------------------------------------------

Agreement 2                =        --------------------------------------------------------


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

This letter responds to a letter dated May 20, 2019, and subsequent correspondence,
submitted on behalf of Company by its authorized representative, requesting a ruling
under §1362(f) of the Internal Revenue Code (Code).
PLR-113034-19                               2


                                         Facts

The information submitted states Company was organized on Date 1 as a limited
liability company under the laws of State. Company’s operating agreement, Agreement
1, included provisions in contemplation of Company being treated as a partnership for
federal income tax purposes; however, the applicability of those provisions was not
limited to such a situation. Agreement 1 included the following partnership provisions:

      (1) Article 4.1 providing, “Allocation of Net Profits. For each taxable year of the
      Company, Net Profits are to be allocated to the Members as follows … First, if
      one … or more Members have a negative Capital Account balance, to those
      Members in proportion to their negative Capital Account balances until all
      negative Capital Accounts have zero balances; provided, however, that no such
      negative Capital Account is to be increased to an amount in excess of zero as a
      result of this Subsection”; and

      (2) Article 4.2 providing “Allocation of Net Losses. For each taxable year of the
      Company, Net Losses are to be allocated to the members as follows subject to
      the provisions of Section 4.3,..First if one or more Members have a positive
      capital account balance, to those members in proportion to their positive Capital
      Account balance until all positive Capital Accounts have zero balances”; and

      (2) Article 4.3 providing, “Distribution of Available Cash … to the Members in
      proportion to their respective positive Capital Account balances until each
      Member has received an amount equal to the balance of his Capital Account”;
      and

      (3) Article 10.2 requiring, in part, “Upon the dissolution of the Company, the
      Members shall proceed to liquidate the Company and the liquidation proceeds
      will be applied and distributed in the following order of priority … to the Members
      in proportion to their respective positive Capital Accounts.”

Taxpayer represents that, on Date 4, Agreement 2 replaced Agreement 1 in order to
eliminate the potential for a second class of stock under § 1361(b)(1)(D). On Date 5,
this office contacted Company’s representative to discuss concerns with the revisions in
Agreement 2, and Company submitted a revised Agreement 2 on Date 6.

In addition, on Date 3, Company issued a membership interest to an individual
retirement account (IRA), an ineligible S corporation shareholder. On Date 4, Company
repurchased all outstanding shares held by the IRA.

Company represents that Company and its shareholders have filed tax returns
consistent with Company having a valid S corporation election in effect as of Date 1. In
accordance with §§ 1362(f) and 1.1362-4, Company and each person who has been a
PLR-113034-19                                3

shareholder of Company at any time on or after Date 1 through the date of the ruling
request have consented to any adjustments as may be required by the Secretary.

Company requests two rulings. First, Company requests relief pursuant to § 1362(f)
due to its governing provisions creating more than one class of stock. Second,
Company requests relief pursuant to § 1362(f) because an ineligible shareholder held
its shares from Date 2 to Date 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) provides that for purposes of subchapter S, the term “small business
corporation” means a domestic corporation, which is not an ineligible corporation and
does not have (A) 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
subsection § 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 1.1361-1(h)(1)(vii) provides that IRAs (including Roth IRAs) are not eligible S
corporation shareholders (except as provided in the limited circumstance in that
section).

Section 1.1361-1(l)(1) 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).

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) shall be terminated
whenever (at any time on or after the 1st day of the 1st taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

Section 1362(f) provides, in part, that if (1) an election under §1362(a) by any
PLR-113034-19                               4

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
(ii) was terminated under §1362(d)(2) or (3); (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; 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 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
during the period specified by the Secretary.

Section 1.1362-4(d) provides, in part, that in the case of stock held by an ineligible
shareholder that causes an inadvertent termination for an S corporation under § 1362(f),
the Commissioner may require the ineligible shareholder to be treated as a shareholder
of the S corporation during the period the ineligible shareholder actually held stock in
the corporation.

                                       Conclusion

Based on the facts submitted and representations made, we conclude that the S
election was ineffective. Company had more than one class of stock due to the
partnership provisions in Agreement 1. We further conclude that had Company's S
corporation election otherwise been effective, Company’s S election would have
terminated on Date 2 when an IRA, an ineligible shareholder under § 1361(b)(1)(B),
received shares in Company. We conclude that the ineffectiveness of Company's S
election as a result of Agreement 1 creating a second class of stock was inadvertent
within the meaning of § 1362(f). We further conclude even if Company’s S election
were otherwise valid, the termination resulting from IRA holding Company shares
constituted an inadvertent termination within the meaning of § 1362(f). Accordingly,
under § 1362(f), Company will be treated as an S corporation from Date 3, and
thereafter, provided the S election for Company is otherwise valid and has not
terminated under § 1362(d).

As a condition for this ruling, for any tax periods between Date 2 and Date 3 in which
Company reported a net loss, the shareholder who was an IRA will be treated as the
shareholder of the shares of stock held by them at that time. For any tax periods
between Date 2 and Date 3 in which Company reported a net gain, the beneficiary of
the IRA will be treated as the shareholders of the shares of stock held by the IRA.
Additionally, Company and its shareholders agree to adopt the revisions to Agreement 2
as submitted to this office on Date 6 within 120 days of the date of this letter.
PLR-113034-19                                5

Except as specifically ruled above, we express or imply no opinion as to the federal
income tax consequences of the facts described above under any other provision of the
Code, including Company’s eligibility to be a valid S corporation.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the
Code provides that it 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.

                                      Sincerely,



                                      ______________________________
                                      Caroline E. Hay
                                      Senior Counsel, Branch 1
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)


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