Corporation keeps S status after correcting unequal stock rights

Plain-English summary

An S corporation’s operating agreements required member capital accounts and tied liquidation distributions partly to those balances. Those provisions created nonidentical distribution and liquidation rights, causing the corporation to have more than one class of stock and terminating its S election. After discovering the problem, the shareholders amended the agreement to remove the capital-account requirement and provide identical rights. The corporation and its owners had consistently filed as an S corporation and made distributions according to ownership percentages. The IRS treated both agreement-based terminations as inadvertent and allowed the corporation to retain S status, provided it remained otherwise eligible.

Ruling snapshot

• Question: Could an S corporation receive inadvertent-termination relief after operating agreements created unequal distribution and liquidation rights?
• Outcome: approved
• Key authorities: IRC §§ 1361(b)(1)(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: 202247004                                        Third Party Communication: None
Release Date: 11/25/2022                                 Date of Communication: Not Applicable
Index Number: 1361.01-04, 1362.02-00,
              1362.04-00                                 Person To Contact:
                                                         --------------------------, ID No. ----------------
----------------                                         -----------------
------------------------                                 Telephone Number:
-----------------------------                            --------------------
------------------------------                           Refer Reply To:
--------------------                                     CC:PSI:B01
                                                         PLR-104931-22
-------------------------------------------------        Date:
                                                         August 30, 2022

                                                   LEGEND

X                = --------------------------------
                   -----------------------
A                = --------------------------------
                   -------------------------
B                = --------------------------------
                   -------------------------
Date 1           = ----------------------

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

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

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

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

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

PLR-104931-22                                2

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

       This responds to a letter dated March 11, 2022, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
relief under section 1362(f) of the Internal Revenue Code (the Code).

                                        FACTS

      The information submitted states that X was formed on Date 1 under the laws of
State and elected to be treated as an S corporation effective Date 2. A and B were the
sole shareholders of X as of Date 3. On Date 3, A and B entered into an Amended and
Restated Operating Agreement that included provisions regarding partnerships.
Section 5.1 of this agreement provides, in part, that X would maintain capital accounts
for each member. Section 10.4 of this agreement provides, in part, that upon liquidation
of X, members would distributions to the extent of their capital account balances
followed by their interests in X.

       On Date 4, A and B entered into a Second Amended and Restated Operating
Agreement that continued to include the same provisions regarding partnerships as the
first Amended and Restated Operating Agreement. Upon discover of the effect of the
partnership provisions, A and B entered into a Third Amended and Restated Operating
Agreement on Date 5 to remove the requirement for the members to maintain capital
accounts and to provide identical distribution and liquidation rights to the members.

       X represents that the termination of X’s S corporation election was inadvertent
and not motivated by tax avoidance. X further represents that since Date 3, X and its
members have filed all returns consistent with X’s status as an S corporation. X also
represents that since Date 3, all distributions were made to the members based on their
pro rata shares of ownership of X. X and its members have agreed to make such
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) defines a “small business corporation” as a domestic
corporation which is not an ineligible corporation and which 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 § 1361(c)(6)) who is not

PLR-104931-22                                 3

an individual, (C) have a nonresident alien as a shareholder, and (D) have more than 1
class of stock.

       Section 1362(f) provides 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 to obtain shareholder consents or (B) was terminated under § 1362(d)(2) or
(3), (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 (A) so that the corporation for which the election was made or the
termination occurred is a small business corporation or (B) to acquire the shareholder
consents, 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.

      Section 1.1361-1(l)(1) of the Income Tax Regulations provides that a corporation
generally 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 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).

                                     CONCLUSION

      Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election terminated on Date 3 due to the provisions in the Amended
and Restated Operating Agreement. We further conclude this termination was
inadvertent under the provisions of § 1362(f). We also conclude that if X’s status had
not terminated on Date 3 it would have terminated on Date 4 due to the provisions in the
Second Amended and Restated Operating Agreement. We conclude that X’s
termination on Date 4 would also have been inadvertent under the provisions of §
1362(f). Therefore, pursuant to § 1362(f), X will be treated as an S corporation effective
Date 3, and thereafter, provided that X is otherwise eligible to be an S corporation and
provided that the election was not otherwise terminated.

PLR-104931-22                                  4

      Except as specifically ruled above, we express or imply no opinion under any
other provisions of the Code. Specifically, we express or imply no opinion as to whether
X otherwise qualifies as 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 the 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.

     This ruling is directed to the taxpayer requesting it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

      Pursuant to a power of attorney on file with this office, a copy of this letter is
being sent to X’s authorized representatives

                                       Sincerely,

                                       ___________________________
                                       Laura C. Fields
                                       Branch Chief, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosure:
     Copy for § 6110 purposes

cc: