Partnership-style operating agreements caused an inadvertent S corporation termination

Plain-English summary

An LLC elected S corporation treatment but later adopted two successive operating agreements containing partnership-style capital-account, allocation, distribution, and liquidation provisions. Those governing provisions gave shareholders nonidentical economic rights and therefore created a prohibited second class of stock, terminating the S election. The second agreement also authorized three stock classes, but only identical Class A shares were actually issued, so the unissued classes did not independently cause a second-class problem. The company and shareholders had reported consistently with S status, represented that the defects were inadvertent and not tax-motivated, and agreed to required adjustments. The IRS granted section 1362(f) relief and treated the company as an S corporation through the later sale to a purchaser, assuming the election was otherwise valid.

Ruling snapshot

• Question: Were the S election terminations caused by partnership-style provisions in two operating agreements inadvertent under section 1362(f)?
• Outcome: approved (the company was treated as continuing to be an S corporation during the affected period)
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                         Department of the Treasury
                                                                 Washington, DC 20224

Number: 202021007                                                Third Party Communication: None
Release Date: 5/22/2020                                          Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.01-02,
              1361.01-04, 1361.05-00,                            Person To Contact:
              1362.00-00, 1362.01-00,                            -----------------------, ID No. -----------------
              1362.01-01                                         Telephone Number:
                                                                 --------------------
--------------------------------                                 Refer Reply To:
------------------------------                                   CC:PSI:03
------------------------------                                   PLR-119888-19
------------------------------                                   Date:
                                                                 February 20, 2019




Legend

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

Purchaser                  =        --------------------

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

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

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

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

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

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

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

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

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

Date 5                     =        --------------------------
PLR-119888-19                                  2

n                     =      -----------

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

This letter responds to a letter dated August 14, 2019 submitted on behalf of Company
by its authorized representative requesting a ruling under §1362(f) of the Internal
Revenue Code (Code).

                                            Facts

The information submitted states Company was organized on Date 1 as a limited
liability company under the laws of State. Company timely filed Form 2553, Election by
a Small Business Corporation, for Company to be an association treated as an S
corporation effective Date 2. From Date 1 to Date 5, A and B were the sole owners of
the Company. On Date 5, A and B sold all the outstanding Company shares to
Purchaser.

Effective on Date 3, the Company Shareholders signed an operating agreement,
Agreement 1. 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) Section 4.4 providing, in part, “A Capital Account … shall be established and
        maintained for each Member … If a Member validly transfers his or her
        Ownership Interest, the Capital Account of the transferring Member shall carry
        over to the transferee Member in accordance with the Code.”

    (2) Section 4.5 providing, “Each Member’s Capital Account shall be adjusted as
        follows:

            a. Increases. Each Member’s Capital Account shall be increased by:
                    i. Capital contribution of cash and/or property at its agreed upon fair
                       market value;
                   ii. All items of LLC income and gain (including income and gain
                       exempt from tax).
            b. Decreases. Each Member’s Capital Account shall be decreased by:
                    i. Distributions of cash and/or property at its agreed upon fair market
                       value;
                   ii. All items of LLC deduction and loss (including deductions and loss
                       exempt from tax).”

    (3) Section 5.3 providing, in part, “if a Member unexpectedly receives any
        adjustment, allocations, or distributions described in Treasury Regulations
        §1.704-1(b)(2)(ii)(d)(4), (5) or (6) or any amendment thereto, or receives an
PLR-119888-19                                  3

       allocation of loss which produces a negative capital account for any Member
       while any other Member has a positive capital account, then items of LLC income
       shall be specifically allocated to such Member until the deficit Capital Account is
       eliminated. This paragraph is intended to constitute a ‘qualified income offset’
       within the meaning of Treasury Regulation §1.704-1(b)(2)(ii)(d).”

   (4) Section 5.4 providing, in part, “if there is a net decrease in LLC ‘minimum gain’
       during a taxable year, each Member shall be specially allocated, before any other
       allocation, items of income and gain for such taxable year (and, if necessary,
       subsequent years) in proportion to each Member's share of the net decrease in
       LLC ‘minimum gain’ as determined in accordance with Treasury Regulation
       §1.704-2(g)(2). This paragraph is intended to comply with the ‘minimum gain
       chargeback’ provisions of Treasury Regulation §1.704-2(f).”

   (5) Section 5.5 providing, in part, “to the extent that Code §704(c) is applicable to
       any item of income, gain, loss, and deduction with respect to any property (other
       than cash) that has been contributed by a Member and which is required to be
       allocated to such Member for income tax purposes, the item shall be allocated to
       such Member in accordance with Code §704(c).”

   (6) Section 5.6 providing, in part, “Distribution of LLC assets and property shall be
       made at such times and in such amounts as the Members determine subject to
       any restrictions in this Agreement. Distributions shall be made among the
       Members in proportion to the Member’s Ownership Interests.”

   (7) Section 12.4 providing, in part, “[u]pon the occurrence of any of the events
       specified above and the completion of winding up all LLC business and affairs,
       the assets of the LLC shall be promptly liquidated and distributed in the following
       order… (c) to the Members in proportion to their Capital Accounts after
       adjustments for all allocations of net profits and net loss.”

These provisions applied from Date 3 until Date 4, a period when Company intended to
be treated as an S corporation.

Effective on Date 4, A and B signed an operating agreement, Agreement 2. Agreement
2 superseded Agreement 1. Agreement 2 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 2 also
provided for three types of stock, Class A (common units), Class
B (incentive units), and Class C (preferred units). The Class A stock was voting
common stock with a pro-rata right to distribution and liquidation proceeds. The Class B
stock was intended to provide a holder with a liquidating distribution only to the extent
the holders of other Company shares first received distributions equal to a previously
established fair market value of Company. The Class C stock was intended to provide
a holder with a first priority distribution to the extent of a holder’s capital contribution to
PLR-119888-19                               4

the extent it was not previously returned. On Date 4, Company issued n shares of
Class A stock to each A and B. No agreement was entered into obligating the issuance
of Class B or C stock, and Company never issued Class B or C stock.

Agreement 2 also included the following partnership provisions:

   (1) Section 5.3 providing, in part, “if a Member unexpectedly receives any
       adjustments, allocations, or distributions described in Treasury Regulations
       §1.704-1(b)(2)(ii)(d)(4), (5) or (6) or any amendment thereto, or receives an
       allocation of loss which produces a negative capital account for any Member
       while any other Member has a positive capital account, then items of LLC income
       shall be specially allocated to such Member such that the deficit Capital Account
       is eliminated. This paragraph is intended to constitute a ‘qualified income offset’
       within the meaning of Treasury Regulation §1.704-1(b)(2)(ii)(d).”

   (2) Section 5.4 providing, in part, “if there is a net decrease in LLC minimum gain
       during a taxable year, each Member shall be specially allocated, before any other
       allocation, items of income and gain for such taxable year (and, if necessary,
       subsequent years) in proportion to each Member's share of the net decrease in
       LLC minimum gain as determined in accordance with Treasury Regulation
       §1.704-2(g)(2). This paragraph is intended to comply with the ‘minimum gain
       chargeback’ provisions of Treasury Regulation §1.704-2(t).”

   (3) Section 5.5 providing in part, “A capital account for each Member (the ‘Capital
       Accounts’) will be established on the Company’s books and records. The Capital
       Accounts will be maintained in accordance with the following provisions:

      5.5.1 To each Member’s Capital Account there shall be added (a) such Member’s
      Capital Contributions, (b) such Member’s allocable share of income, gain and
      profit and any items in the nature of income or gain that are specially allocated to
      such Member pursuant to this Agreement, and (c) the amount of any Company
      liabilities assumed by such Member or which are secured by any property
      distributed to such Member.

      5.5.2 From each Member’s Capital Account there shall be subtracted (a) the
      amount of cash and the fair market value of any Company assets (other than
      cash) distributed to such Member (other than any payment of principal and/or
      interest to such Member pursuant to the terms of a loan made by the Member to
      the Company) pursuant to any provision of this Agreement, (b) such Member’s
      allocable share of losses, deduction and expense and any other items in the
      nature of expenses or losses that are specially allocated to such Member
      pursuant to this Agreement, and (c) liabilities of such Member assumed by the
      Company or which are secured by any property contributed by such Member to
      the Company.
PLR-119888-19                                 5

     5.5.3 In the event any interest in the Company is transferred in accordance with
     the terms of this Agreement, the transferee shall succeed to the Capital Account
     of the transferor to the extent it relates to the transferred interest.

     5.5.4 The foregoing provisions and the other provisions of this Agreement
     relating to the maintenance of Capital Accounts are intended to comply with
     Regulations Sections §1.704-1(b) and §1.704-2 and shall be interpreted and
     applied in a manner consistent with such Regulations. In the event that the
     Managers shall determine that it is prudent to modify the manner in which the
     Capital Accounts, or any additions or subtractions thereto, are computed in order
     to comply with such Regulations, the Managers may make such modification,
     provided that it is not likely to have a material effect on the amounts distributable
     to any Member upon the dissolution of the Company.”

  (4) Section 5.7 providing, “Tax Distributions. For so long as the Company has
      elected to be treated as a partnership for tax purposes, the Managers shall cause
      the Company to make distributions of Available Amounts as soon as is
      practicable following the close of any tax period, to each of the Members in
      amounts up to and in proportion to each such Member's Presumed Tax Liability
      (as defined below) with respect to such period (in necessary [sic], as estimated
      by the Managers based on the results of such period). Any amounts distributed
      to a Member pursuant to this Section 5.7 shall be treated as a dollar-for-dollar
      advance against the first amounts otherwise attributable to such Member
      pursuant to Section 5.6, above. ‘Presumed Tax Liability’ shall mean, with respect
      to any Member, the amount determined by multiplying the highest marginal U.S.
      federal income tax rate (applicable to the character of the income in question)
      applicable to corporations or individuals, as applicable, for such fiscal year, not to
      exceed forty percent (40%) by the excess of the taxable income or gain for such
      period which is allocable to such Member under this Article 5, over deductions
      allocated to such Member under this Article 5 for the same period.”

  (5) Section 8.3 providing, in part, “[e]ach Member shall look solely to the assets of
      the Company for all distributions with respect to the Company, its Capital
      Contribution thereto, its Capital Account and its share of income, gain, profits,
      losses, deduction, expense and credit of the Company, and shall have no
      recourse therefor (upon dissolution or otherwise) against any other Member.
      Accordingly, if any Member has a deficit balance in its Capital Account (after
      giving effect to all contributions, distributions and allocations for all taxable years,
      including the year during which the liquidation occurs), then such Member shall
      have no obligation to make any Capital Contribution with respect to such deficit,
      and such deficit shall not be considered a debt owed to the Company or to any
      other person for any purpose whatsoever.”

  (6) Section 8.4 providing, in part, ”Upon the occurrence of a dissolution event
      described in Section 8.1 above, the Company shall terminate. In the event of the
PLR-119888-19                               6

      dissolution and termination of the Company, the Managers shall proceed with an
      orderly liquidation of the Company and the proceeds of such liquidation shall be
      applied and distributed in the following order of priority:

      8.4.1 To creditors of the Company, whether they are or are not Members, for
      payment of the debts and liabilities of the Company and the expenses of
      liquidation;

      8.4.2 To the setting up of any reserves that the Managers may deem reasonably
      necessary for any contingent or unforeseen liabilities or obligations of the
      Company. Such reserves shall be paid over by the Managers to a bank or other
      institutional escrow agent to be held for the purpose of disbursing such reserves
      in payment of the aforementioned contingencies, and at the expiration of such
      period as the Managers may deem advisable, to distribute the balance in the
      manner provided in this Section 8.4; and

      8.4.3 To the Class C Members to the extent of any Unreturned Capital Amount
      with respect to each such Class C Member;

      8.4.4 To the Class A Members and the Class B Members to the extent of any
      Unreturned Capital Amount to each such Member;

      8.4.5 To the Members in accordance with Section 5.6, above; and,

      8.4.6 Notwithstanding the provisions of 8.4.3, 8.4.4. and 8.4.5, priority shall be
      given to the Additional Units consistent with the terms upon which such units are
      granted.”

Company requests two rulings. First, the termination of Company’s S corporation
election on Date 3 was inadvertent within the meaning of section 1362(f). Second,
pursuant to the provisions of section 1362(f), the Taxpayer will be treated as an S
corporation at all times since Date 3 until Date 5, provided that Company’s S
corporation election did not otherwise terminate.

Company represents that the circumstances resulting in the termination of its S election
under §1362(a) were inadvertent and not motivated by tax avoidance or retroactive tax
planning. Company states that Company and its shareholders have filed their federal
income tax returns consistent with having a valid S corporation election in effect for
Company. Company and its shareholders have agreed to make such adjustments
(consistent with the treatment of Company as an S corporation) as may be required by
the Secretary.

                                   Law and Analysis

Section 1362(a) provides that, except as provided in §1362(g), a small business
PLR-119888-19                                7

corporation may elect, in accordance with the provisions of §1362, to be an S
corporation.

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 the term “small business corporation” means 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) 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 1.1361-1(l)(3) provides that, except as provided in §1.1361-1(b)(3), (4), and (5)
(relating to restricted stock, deferred compensation plans, and straight debt), in
determining whether all outstanding shares of stock confer identical rights to distribution
and liquidation proceeds, all outstanding shares of stock of a corporation are taken into
account.

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) and the regulations thereunder provide relief for an inadvertent
termination of an S corporation election provided the following conditions are met:

   a. The corporation made an election under §1362(a) or §1361(b)(3)(B)(ii) that was
      ineffective or was terminated;

   b. The Service determines that circumstances resulting in the ineffectiveness or
      termination were inadvertent;

   c. Steps were taken by the corporation to qualify it as a small business corporation
PLR-119888-19                                 8

       or qualified subchapter S subsidiary (QSub) within a reasonable period of time
       after discovery of the termination event; and

   d. The corporation and all shareholders agree to any adjustments that the Service
      may require for the period.

                                        Conclusion

Based on the facts submitted and representations made, the S election effective on
Date 2 was terminated on Date 3 because Company had more than one class of stock
due to the partnership provisions in Agreement 1, which was effective on Date 3. If
Company's S election had not terminated on Date 3, Company's S election would have
terminated on Date 4 because Company had more than one class of stock due to
partnership provisions in Agreement 2, which was effective on Date 4.

We conclude the termination of the S election for Company, as a result of Agreement 1
creating a second class of stock was inadvertent within the meaning of §1362(f). We
also conclude that the termination of Company’s S election, as a result of Agreement 2,
creating a second class of stock, was inadvertent. Accordingly, under §1362(f),
Company will be treated as an S corporation from Date 3 to Date 5 provided the S
election for Company was otherwise valid and has not terminated. Because the
Company states it was never obligated to issue and never did issued Class B or Class
C stock, such stock was not outstanding and, thus, did not create a second class of
stock for purposes of §1.1361-1(l)(1).

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provision of the
Code. In particular, we express or imply no opinion regarding the validity of Company’s
S election between Date 2 and Date 3.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) of the
Code provides that 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.
PLR-119888-19                                9


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


                                      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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