S corporation keeps its status after an operating agreement accidentally created a second class of stock

Plain-English summary

An S corporation is allowed only one class of stock, meaning all shares must confer identical rights to distributions and liquidation proceeds. Here a corporation adopted an operating agreement whose distribution provision tied payouts both to positive capital-account balances and to ownership percentages, which the corporation acknowledged created a prohibited second class of stock and terminated its S election. After learning of the problem, the corporation replaced the offending agreement with a corrected one and asked the IRS for relief under § 1362(f), which lets the IRS overlook an inadvertent termination when the company promptly fixes it and the shareholders agree to be treated consistently. The IRS concluded the termination was inadvertent and not motivated by tax avoidance, so it treated the corporation as continuing to be an S corporation from the date the flawed agreement took effect. This matters because a "second class of stock" problem is a common, easily overlooked way to lose S status, and § 1362(f) is the standard cure.

Ruling snapshot

• Question: Was the termination of the corporation's S election (from a one-class-of-stock violation in its operating agreement) inadvertent under § 1362(f)?
• Outcome: Approved (relief granted; treated as continuing S corporation)
• Key authorities: IRC §§ 1362(f), 1361(b)(1)(D); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

 Internal Revenue Service                                      Department of the Treasury
                                                               Washington, DC 20224

 Number: 202238009                                             Third Party Communication: None
 Release Date: 9/23/2022                                       Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.02-00,
               1362.02-02, 1362.04-00                          Person To Contact:
                                                               --------------------, ID No. -----------------
 -------------------                                           Telephone Number:
 ---------------------------------                             --------------------
 --------------------------------------------                  Refer Reply To:
 ------------------------                                      CC:PSI:03
 -----------------------------                                 PLR-107430-22
                                                               Date:
                                                               June 30, 2022




Legend

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

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

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

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

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

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



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

       This letter responds to a letter dated April 7, 2022, 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 X was incorporated under the laws of State and
elected to be treated as an S corporation on Date 1.
PLR-107430-22                                2

       Effective Date 2, X adopted an operating agreement, Agreement 1, containing
terms causing X to have more than one class of stock under § 1361(b)(1)(D).
Specifically, section 5.03 of Agreement 1 states that distributions are to be made in
accordance with positive capital account balances and also per ownership percentages.

        X represents that Agreement 1 created a second class of stock, causing X's S
corporation status to terminate. Upon learning that Agreement 1 terminated X's S
election, X replaced Agreement 1 with Agreement 2. X represents that the termination
of its S corporation election was inadvertent and not motivated by tax avoidance. The
shareholders of X have consented to make any adjustments 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 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
PLR-107430-22                                 3

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 X's
S election terminated on Date 2, when X signed Agreement 1. We further conclude that
the termination was inadvertent within the meaning of § 1362(f). Accordingly, under
§ 1362(f), X will be treated as continuing to be an S corporation on and after Date 2,
provided that X's S corporation election was valid and not otherwise terminated under
§ 1362(d).

       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 X's eligibility to be a valid S corporation.

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

       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
PLR-107430-22                                4


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)




Enclosure:
      Copy for 6110 purposes



cc: