S corporation keeps its status after fixing second-class-of-stock provisions

Plain-English summary

A limited liability company had elected S corporation status and later issued restricted membership units to two service providers. When those units vested, partnership-style provisions in the operating agreement gave the company more than one class of stock, terminating its S election under IRC § 1362(d). The company amended the agreement to remove those provisions and made corrective distributions after discovering that earlier distributions had not been proportionate. It represented that the problem was inadvertent, was not motivated by tax avoidance, and had been reported consistently with continued S status. The IRS granted inadvertent-termination relief under § 1362(f), treating the company as an S corporation continuously from the termination date, assuming its election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Can the company retain continuous S corporation treatment after its operating agreement created a second class of stock?
• Outcome: Approved as an inadvertent termination
• Key authorities: IRC §§ 83, 1361, and 1362; Treas. Reg. §§ 1.83-3 and 1.1361-1

Full text (IRS public release)

 Internal Revenue Service                                          Department of the Treasury
                                                                   Washington, DC 20224

 Number: 202110010                                                 Third Party Communication: None
 Release Date: 3/12/2021                                           Date of Communication: Not Applicable
 Index Numbers: 1361.01-04, 1362.00-00,
               1362.04-00                                          Person To Contact:
                                                                   ----------------------, ID No. ------------------
 ----------------------- ------                                    Telephone Number:
 --------------------------------------------                      -------------------
 ------------------------------                                    Refer Reply To:
 ---------------------------------                                 CC:PSI:B3
                                                                   PLR-114756-20
                                                                   Date:
                                                                   December 9, 2020




Legend:

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

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

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

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

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

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

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

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

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

Date 3                     =        ----------------------
PLR-114756-20                                        2


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

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

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

Date 7                  =   -----------------

Years                   =   ------------------------------



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

This letter responds to a letter dated June 29, 2020, and subsequent correspondence,
submitted on behalf of X by its authorized representatives requesting a ruling under
§ 1362(f) of the Internal Revenue Code (Code).

                                                Facts

The information submitted states that X was organized on Date 1 as a limited liability
company under the laws of State and elected to be an S corporation effective Date 2.
A was the sole member of X on Date 2. On Date 3, pursuant to an employment
agreement, X issued restricted membership units to B. B did not make an election
under § 83(b) with respect to those units. B’s restricted membership units in X began
vesting on Date 4. On Date 5, pursuant to an employment agreement, X issued
restricted membership units to C. C did not make an election under § 83(b) with respect
to those units. C’s restricted membership units in X began vesting on Date 6.

X’s operating agreement that was in effect on Date 4 and Date 6, Agreement 1,
contained terms causing X to have more than one class of stock under § 1361(b)(1)(D).
Provisions in Agreement 1, including partnership provisions that applied irrespective of
whether X was a partnership, failed to confer identical rights to distribution and
liquidation proceeds. For instance, section 10.5 of Agreement 1, provided, in part, that
in the event X is liquidated within the meaning of § 1.704-1(b)(2)(ii)(g) of the Income Tax
Regulations, distributions shall be made to the members who have positive capital
accounts in compliance with § 1.704-1(b)(2)(ii)(b)(2).

Once X learned its S corporation election terminated on Date 4, it amended and
restated its operating agreement effective Date 7 (Agreement 2) to remove the terms in
Agreement 1 causing X to have more than one class of stock under § 1361(b)(1)(D).

In addition, during Years, X made distributions to A, but failed to make proportionate
distributions to B and C. X has since made correcting distributions to B and C.
PLR-114756-20                                3



X represents that the circumstances resulting in the termination of its S corporation
election under § 1362(f) were inadvertent and not motivated by tax avoidance or
retroactive tax planning. X states that X and its shareholders have filed their federal
income tax returns consistent with X having a valid S corporation election in effect. X
and its shareholders have agreed to make adjustments (consistent with the treatment of
X as an S corporation) 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 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(b)(3) provides that for purposes of subchapter S, stock that is issued
in connection with the performance of services (within the meaning of § 1.83-3(f)) and
that is substantially nonvested (within the meaning of § 1.83-3(b)) is not treated as
outstanding stock of the corporation, and the holder of that stock is not treated as a
shareholder solely by reason of holding the stock, unless the holder makes an election
with respect to the stock under § 83(b).

Section 1.1361-1(l)(1) provides, in part, that a corporation that has more than one class
of stock does not qualify as a small business corporation. Except as provided in
§ 1.1361-1(l)(4) (relating to instruments, obligations, or arrangements treated as a
second class of stock), a corporation is 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, 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 law, and binding agreements relating to distribution and liquidation
proceeds (collectively, the 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 or amount are to be given
appropriate tax effect in accordance with the facts and circumstances.
PLR-114756-20                                 4



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) 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. Any termination under § 1362(d)(2) is effective on and after the date of
cessation.

Section 1362(f) provides, in part, that if (1) an election under § 1362(a) by any
corporation was terminated under § 1362(d)(2); (2) the Secretary determines that the
circumstances resulting in the termination were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in the
termination, steps were taken so that the corporation for which the termination occurred
is a small business corporation; and (4) the corporation for which the termination
occurred, and each person who was a shareholder of the corporation at any time during
the period specified pursuant to §1362(f), agrees to make such adjustments (consistent
with the treatment of the corporation as an S corporation) as may be required by the
Secretary with respect to such period, then, notwithstanding the circumstances resulting
in the termination, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

                                        Conclusion

Based on the representations made and information submitted, we conclude that X’s S
corporation election terminated on Date 4 because X had more than one class of stock
due to the partnership provisions in Agreement 1. We conclude, however, that the
circumstances resulting in the termination of X’s S corporation election were inadvertent
within the meaning of § 1362(f). Accordingly, under § 1362(f), X will be treated as an S
corporation from Date 4 and thereafter provided that X’s S corporation election was
otherwise valid and has not otherwise terminated under § 1362(d).

Except as expressly provided herein, we express or imply no opinion concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

Under a power of attorney on file with this office, we are sending a copy of this letter to
your authorized representatives.
PLR-114756-20                               5



This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3)
of the Code, 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.


                                                Sincerely,



                                                Mary Beth Carchia
                                                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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