Partnership-style operating agreement receives S corporation relief

Plain-English summary

A limited liability company's operating agreement used partnership provisions that gave members liquidation rights based on capital account balances instead of membership interests. Those provisions created a second class of stock and made the company's S corporation election ineffective. After discovering the problem, the company amended its agreement and represented that it and its shareholders had consistently filed as an S corporation. The IRS found the ineffectiveness inadvertent under Section 1362(f) and treated the company as an S corporation from the intended election date forward, assuming the election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: May the company receive inadvertent-election relief after its operating agreement created more than one class of stock?
• Outcome: Approved. The company is treated as an S corporation from its intended effective date forward.
• Key authorities: IRC §§ 1361 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: 202111011 Third Party Communication: None
Release Date: 3/19/2021 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------- -------------------, ID No. ---------------
----------------------------------------- Telephone Number:
----------------------------------- --------------------
----------------------------------- Refer Reply To:
CC:PSI:B03
PLR-115272-20
Date:
December 22, 2020

LEGEND:

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

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

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

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

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

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

   This letter responds to a letter dated July 8, 2020, and subsequent

correspondence, submitted on behalf of X by its authorized representative requesting a
ruling under § 1362(f) of the Internal Revenue Code (Code).

                                                    FACTS

    The information submitted states that X was formed on Date 1 under the laws of

State and elected to be an S corporation effective Date 2. X’s operating agreement
effective Date 2 contained terms causing X to have more than one class of stock under
§ 1361(b)(1)(D). The agreement included partnership provisions that failed to provide
identical distribution and liquidation rights to X’s members and applied irrespective of
whether X was a partnership. Specifically, section 9.3(c) of the agreement required X to
make liquidating distributions to its members in accordance with each member’s
PLR-115272-20 2

positive capital account balance, rather than pro rata based on membership interests.
Thus, X’s S corporation election effective Date 2 was ineffective.

   X represents that once it learned that its S corporation election was ineffective, it

amended and restated its operating agreement on Date 3 to remove the terms causing
X to have more than one class of stock under § 1361(b)(1)(D).

   X represents that the circumstances surrounding X’s ineffective S corporation

election were inadvertent and unintended. X further represents that for each taxable
year beginning Date 2, X and its shareholders have filed consistently with X being an S
corporation. In addition, X and its shareholders agree to make any adjustments that
may be required by the Secretary as a condition of obtaining relief under § 1362(f).

                              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, 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) 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(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, governing provisions).

  Section 1362(a)(1) provides that, except as provided in § 1362(g), a small

business corporation may elect 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 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 effective on and after the date of cessation.
PLR-115272-20 3

    Section 1362(f) provides, in part, that if (1) an election under § 1362(a) by any

corporation (A) 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 (B) was terminated under § 1362(d)(2), (2) the Secretary determines that
the circumstances resulting in the ineffectiveness or termination were inadvertent, (3) no
later than a reasonable period of time after discovery of the circumstances resulting in
the 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), 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
ineffectiveness or termination, the corporation will be treated as an S corporation during
the period specified by the Secretary.

                                 CONCLUSION

   Based solely on the facts submitted and the representations made, we conclude

that X’s S corporation election was ineffective on Date 2 as a result of X having more
than one class of stock due to the partnership provisions in X’s operating agreement.
We conclude, however, that the circumstances resulting in the ineffectiveness were
inadvertent within the meaning of § 1362(f). Therefore, under § 1362(f), X will be
treated an S corporation effective Date 2 and thereafter, provided that its S corporation
election is otherwise valid and has not otherwise terminated under § 1362(d).

   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. Specifically, we express or imply no opinion on whether X is
otherwise eligible to be an S corporation.

   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-115272-20 4

   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.

    Pursuant to a power of attorney on file with this office, we are sending a copy of

this letter to your authorized representative.

                                                      Sincerely,




                                                      Mary Beth Carchia
                                                      Senior Technician Reviewer, Branch 3
                                                      Office of Associate Chief Counsel
                                                      (Passthroughs & Special Industries)

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

cc: ----------------------