IRS grants relief for an ineffective S corporation election caused by operating agreement provisions

Plain-English summary

A limited liability company elected S corporation status, but provisions in its operating agreement caused it to be treated as having more than one class of stock. That meant the company did not qualify as a small business corporation when it made the election. After discovering the problem, the company and its owners replaced the agreement and represented that allocations had been made in proportion to ownership interests. The IRS concluded that the ineffective election was inadvertent under IRC § 1362(f) and allowed the company to be treated as an S corporation from the requested effective date. The relief required the company and its shareholders to file all required returns consistent with that treatment within 120 days.

Ruling snapshot

• Question: Could an S corporation election that was ineffective because the operating agreement created more than one class of stock receive inadvertent-election relief?
• Outcome: Approved.
• Key authorities: IRC §§ 1361(a), 1361(b), 1362(a), 1362(d), 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: 202053005 Third Party Communication: None
Release Date: 12/31/2020 Date of Communication: Not Applicable
Index Numbers: 1361.01-04, 1362.00-00,
1362.02-00, 1362.04-00 Person To Contact:
-----------------------, ID No. -----------------
------------------------------- Telephone Number:
------------------------------------------------- --------------------
------------------------------------------------- Refer Reply To:
---------------------------------- CC:PSI:03
PLR-109292-20
Date:
October 06, 2020

Legend

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

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

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

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

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

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

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

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

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

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

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

C = -------------------------------------------

PLR-109292-20 2

D = --------------------------------------------------------

E = -------------------------------------------

a = ---------

b = ---------

c = ---------

d = ---

e = ---

f = ---

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

This letter responds to a letter dated April 3, 2020, and subsequent correspondence,
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. On Date 2 an operating agreement,
Agreement 1, was executed and 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. On Date 4 Company
made an election to be an S corporation effective Date 3. On and after Date 3, the
owners of Company were and are A, B, C, D, and E each an eligible S corporation
shareholder.

Agreement 1 included the following provisions:

Article I provided,

     ‘LLC Units’ or ‘Units’ means measures of ownership in the LLC. The capital
     structure of the LLC shall consist of Units all of the same class with equal rights
     for all purposes under this Operating Agreement.

PLR-109292-20 3

   ‘LLC Unit Percentage’ means with respect to an LLC member, the percentage
   derived from the following fraction: number of LLC Units held by such Member
   divided by the total number of LLC Units held by all Members (and, thereafter,
   multiplying said fraction by 100 to arrive at a percentage).

   Article III, Section 3.1 provided,

   Members. The name, initial capital contribution, LLC Units and LLC Unit
   Percentage of the Members are set forth in the below table, which shall be
   amended from time to time to reflect the admission of new Members.

    Member Name           Initial Capital       Units             LLC%
                          Contribution
    A                     a                     b                 d%
    B                     a                     c                 e%

Article V, Section 5.1 provided,

   The capital structure of the Company shall consist of one class of LLC Units
   having equal rights under all provisions of this operating agreement.

Article VI, Section 6.1 provided,

   Allocations to Capital Accounts. Except as may be required by the Internal
   Revenue Code (Title 26 of the United States Code) or the Treasury Regulations
   (Title 26 of the Code of Federal Regulations) or this Operating Agreement, net
   profits, net losses, and other items of income, gain, loss, deduction and credit of
   the Company shall be allocated among the Members ratably in proportion to
   each Member's LLC Unit Percentage. For example, if a Member has an LLC Unit
   Percentage of f%, he or she shall be allocated f% of all profits and losses (and
   other allocation items) for any given tax year.

   a. Notwithstanding the foregoing, no item of loss or deduction of the Company
   shall be allocated to a Member to the extent such allocation would result in a
   negative balance in such Member's capital account if other Members then have
   positive balances in their capital accounts. Such loss or deduction shall be
   allocated first among the Members with positive balances in their capital
   accounts in proportion to (and to the extent of) such positive balances and
   thereafter to Members in accordance with their Unit Percentages.

Article VI, Section 6.2 provided,

   Tax Allocations. In the case of any special tax allocations allowed under the
   Internal Revenue Code or Treasury Regulations, the method of allocation
   and formula determined by the Tax Matters Partner shall be followed so long

PLR-109292-20 4

   as it complies with state law, the Internal Revenue Code, the Treasury
   Regulations, and fairly treats each Member. The method of tax allocation
   selected by the Tax Matters Partner shall be presumed to be “fair to all the
   members” and any Member or party challenging said al location on these
   grounds shall bear the burden of proof.

Article VI, Section 6.3 provided,

   Distributions. The Company Members by resolution issued pursuant to
   this agreement, may make distributions to the Members from time to time in
   amounts it deems appropriate; however, no distribution shall be declared or
   made if, after giving it effect, the Company would not be able to pay its debts
   as they become due in the usual course of business or the Company's total
   assets would be less than the sum of its total liabilities.

Article VIII, Section 8.1 provided,

   Dissolution. The Company shall be dissolved upon the occurrence of the
   following event (hereinafter, a “Liquidation Event”): a supermajority vote in
   interest of Members to dissolve the Company. Despite any provision of state law
   to the contrary, no other event--including (but not limited to) the withdrawal,
   removal, death, insolvency, liquidation, dissolution, expulsion, bankruptcy, or
   physical or mental incapacity of a Member--shall cause the existence of the
   Company to terminate or dissolve.

Article VIII, Section 8.2 provided,

   Liquidation.

   ***

   b. Should a Liquidation Event occur, the Company shall then be liquidated and its
   affairs shall be wound up-- including preparation of final financial statements and
   an accounting--by (or at the direction of) the Company Members. All proceeds
   from the liquidation shall be distributed in accordance with state law, and all LLC
   Units shall, thereafter, be cancelled. Distributions to the Members shall be made
   in accordance, and proportion, with the Members' relative Capital Account
   balances.

   c. Final distributions to Members shall not be made until all liabilities have
   been satisfied and any contingent claims against the Company have been
   resolved.

   d. Upon the completion of the liquidation and distribution of the Company’s
   assets, the Company shall be terminated and the Managers shall cause the

PLR-109292-20 5

   Company to execute and file a certificate of cancellation in accordance with state
   law.

Upon learning that Agreement 1’s made Company’s S election ineffective, Company
and A, B, C, D and E executed Agreement 2 that replaced Agreement 1.

Company makes the following eight representations. First, Company intended to file a
valid election to be treated as an S corporation, as defined in §1361(a)(1), effective
Date 3. Second, Company’s election was ineffective solely because of Company being
treated as having more than one class of stock for purposes of §1361(b)(1)(D) due to
certain provisions in Agreement 1. Because Company had more than one class of
stock outstanding at the time that it filed its S election, Company failed to qualify as a
small business corporation at the time of filing, causing the S election to be invalid.
Third, the Federal income tax returns of Company have been filed for all relevant
periods consistent with Company having a valid S election in effect on Date 3 and
thereafter, unless its S election otherwise terminates under §1362(d). Fourth, the
Federal income tax returns of Company’s members have been or will be filed, for all
relevant periods, consistent with Company having a valid S election in effect on Date 3
and thereafter, unless its S election otherwise terminates under §1362(d). Fifth, since
Date 3, items of income, gain, loss and deduction were made in proportion to each
owner’s interest in Company. Sixth, as of Date 4, Company, A, B, C, D and E made
corrective steps so that Company qualified as a small business corporation within the
meaning of §1361(b)(1). Seventh, Company represents that the termination of
Company's S corporation election was inadvertent and not motivated by tax avoidance.
Eighth, Company and its members have agreed to make such adjustments consistent
with the treatment of Company as an S corporation as may be required by the
Secretary.

Company requests relief pursuant to §1362(f) due to Agreement 1 having governing
provisions that created more than one class of stock.

                                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(l)(1) provides, in part, that a corporation is generally treated as having
PLR-109292-20 6

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
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.

                                    Conclusion

Based on the facts submitted and representations made, we conclude that Company’s
S election with an effective date of Date 3 was an inadvertent ineffective election 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 on Date 3 and has not otherwise terminated.

This ruling is contingent on Company and its shareholders must file, if not done so
already, within 120 days of the date of this letter, all required federal income tax returns
and information returns (including amended returns) consistent with the requested relief.
PLR-109292-20 7

A copy of this letter should be attached to each such filing.

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,



                                   ______________________________
                                   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

cc: