Defective governing terms and missing consent did not prevent S status

Plain-English summary

A company's S corporation election was ineffective because its operating agreement created more than one class of stock and one shareholder did not sign Form 2553. A later amendment left the same unequal distribution and liquidation terms in place, but the company eventually amended the agreement so all units had identical rights. The company and its shareholders had consistently filed as an S corporation and represented that they did not intend to terminate that status. The IRS treated the ineffective election as inadvertent under section 1362(f) and recognized S corporation status from the intended effective date. As a condition, every shareholder who had not signed Form 2553 had to submit the required consent statement within 120 days.

Ruling snapshot

• Question: May the company be treated as an S corporation despite unequal governing terms and a missing shareholder consent?
• Outcome: approved (missing shareholder consents had to be filed within 120 days)
• Key authorities: IRC §§ 1361(a) and (b), and 1362(a), (d), and (f); Treas. Reg. §§ 1.1361-1(l) and 1.1362-6(b)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202019007 Third Party Communication: None
Release Date: 5/8/2020 Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.02-02,
1361.01-04 Person To Contact:
------------------, ID No. -----------------
------------------------------- Telephone Number:
---------------------------------------------------- --------------------
---------------------------- Refer Reply To:
--------------------------- CC:PSI:B01
PLR-111829-19
Date:
November 29, 2019

LEGEND

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

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

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

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

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

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

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

This responds to a letter dated May 17, 2019, submitted on behalf of X by X’s
authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code.

FACTS

According to the information submitted and representations within, X was formed on
Date 1, under the laws of State. Effective Date 2, X elected to be treated as an S
corporation.

PLR-111829-19 2

On Date 2, X’s operating agreement contained terms causing X to have more than one
class of stock. Specifically, the agreement provided for the maintenance of capital
accounts for each member with each account adjusted for capital contributions, income,
gain, loss, deductions, and distributions made to the member. The capital accounts
were not proportionate to membership interests. The agreement also provided that
liquidation proceeds were to be distributed in accordance with capital accounts rather
than pro rata based on membership interests. In addition, on Date 2, X’s Form 2553
was missing the signature of one of X’s shareholders. Thus, X’s S election on Date 2
was ineffective.

On Date 3, X amended its operating agreement. However, the operating agreement still
contained the same terms that caused X to have more than one class of stock. Thus,
had X’s S corporation election not been ineffective on Date 2, X’s S corporation election
would have terminated on Date 3.

X represents that it has taken corrective action by amending its operating agreement on
Date 4 to provide that all outstanding units in X have identical distribution and liquidation
proceeds.

X represents that neither X nor its shareholders intended to terminate X’s S election and
that X and its shareholders have filed consistently with X being an S corporation. In
addition, X represents that, other than the ineffective S election on Date 2 and the
potential termination due to a second class of stock on Date 3, X has qualified as a
small business corporation at all times since its election on Date 2. Lastly, X and its
shareholders agree to make any adjustments required as a condition of obtaining relief
under the inadvertent termination rule as provided under § 1362(f) as may be required
by the Secretary.

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, and 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(d)(2)(A) 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. Section 1362(d)(2)(B) further provides that the termination shall be

PLR-111829-19 3

effective on and after the date of cessation.

Treas. Reg. § 1.1361-1(I)(1) of the Income Tax Regulations provides 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(I)(2)(i) provides, in part, 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). Although a corporation is not treated as
having more than one class of stock so long as the governing provisions provide for
identical distribution and liquidation rights, any distributions (including actual,
constructive, or deemed distributions) that differ in timing and amount are to be given
appropriate tax effect in accordance with the facts and circumstances.

Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a) by any
corporation 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; (2) the Secretary determines that the circumstances
resulting in such ineffectiveness were inadvertent; (3) no later than a reasonable period
of time after discovery of the circumstances resulting in such 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
pursuant to § 1362(f), agrees to make the adjustments (consistent with the treatment of
such corporation as an S corporation) as may be required by the Secretary with respect
to such period, then, notwithstanding the circumstances resulting in such
ineffectiveness, such corporation shall be treated as an S corporation during the period
specified by the Secretary.

CONCLUSION

Based on the facts submitted and the representations made, we conclude that X’s S
election was ineffective on Date 2, and the ineffectiveness of X’s S corporation 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 election is not otherwise
terminated under § 1362(d).

As a condition of this ruling, any shareholder of X that did not sign X’s Form 2553 must
sign a written statement as described in § 1.1362-6(b)(1) consenting to X's S election
effective Date 2. The written statement(s) must be filed with the appropriate service
center within 120 days from the date of this letter, indicating that the statement(s) are to
be associated with X's originally filed Form 2553.

PLR-111829-19 4

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 who requested it. According to § 6110(k)(3),
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.

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

                                 Sincerely,

                                 Joy C. Spies
                                 Joy C. Spies
                                 Senior Technician Reviewer, 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

cc: