LLC kept S corporation status despite agreements creating a second stock class

Plain-English summary

A limited liability company elected S corporation treatment while operating agreements gave its owners different rights to regular and liquidating distributions. The agreements required capital accounts and made those accounts control how assets would be divided on liquidation, which created a prohibited second class of stock. After discovering the problem, the company adopted a replacement agreement to correct it. The company and its shareholders had consistently filed returns as an S corporation, represented that the defect was inadvertent rather than tax planning, and agreed to any required adjustments. The IRS ruled that the election's ineffectiveness was inadvertent and treated the company as an S corporation from the intended effective date forward, assuming the election was otherwise valid and had not later terminated.

Ruling snapshot

• Question: Could the company retain S corporation treatment when successive operating agreements inadvertently created a second class of stock?
• Outcome: approved, the S election is treated as effective from its intended date
• 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: 202249004                                                Third Party Communication: None
 Release Date: 12/9/2022                                          Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.02-00,
               1362.04-00                                         Person To Contact:
                                                                  --------------------------, ID No. ----------------
 --------------------                                             -----------------
 -----------------------------------------------------            Telephone Number:
 ------------------------------                                   --------------------
 --------------------------------------                           Refer Reply To:
 --------------------------------                                 CC:PSI:B01
                                                                  PLR-105657-22
                                                                  Date:
                                                                  September 14, 2022




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

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

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

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

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

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

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

Agreement 3 =              ------------------------------------

Agreement 4 =              --------------------------------------

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

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

Date 3            =        ------------------
PLR-105657-22                                        2

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

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

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

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


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

This letter responds to a letter dated March 10, 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 that X was organized on Date 1 as a limited liability
company under the laws of State. A and B were the sole members of X.

Effective Date 2, X filed Form 2553, Election by a Small Business Corporation, for X to
be treated as an S corporation. At the time of the election, A and B had a written
operating agreement, Agreement 1.

The provisions of Agreement 1 applied until Date 3, when Agreement 2 replaced
Agreement 1. On Date 4, Agreement 3 replaced Agreement 2. On Date 5, C and D
were issued shares of X. The provisions of Agreement 1, Agreement 2, and Agreement
3 entitled A, B, C, and D to different rights concerning regular and liquidating
distributions, and thus created a second class of stock. Specifically, sections of
Agreement 1, Agreement 2, and Agreement 3 required X to maintain capital accounts
and provided that capital accounts would control the division of assets on liquidation.
After discovering the second class of stock issue, X took corrective action by executing
Agreement 4 on Date 6.

X requests a ruling that due to the provisions of Agreement 1, Agreement 2, and
Agreement 3, X's S election was inadvertently ineffective within the meaning of
§ 1362(f), and X will be treated as an S corporation from Date 2 and thereafter.

X represents that the ineffectiveness of its S election was inadvertent and was not
motivated by tax avoidance or retroactive tax planning. X also represents that X and its
shareholders agree to make any adjustments required as a condition of obtaining relief
under the inadvertent invalid election rule as provided under § 1362(f) of the Code that
may be required by the Secretary. X and its shareholders represent that they have filed
all returns consistent with X being an S corporation.
PLR-105657-22                                3

LAW AND ANALYSIS

Section 1362(a) 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 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(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(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) and the regulations thereunder provide relief for an ineffective S
corporation election (i.e., treating the ineffective election as effective) or inadvertent
termination of an S corporation election provided the following conditions are met: (A)
The corporation made an election under § 1362(a) that was ineffective or was
terminated; (B) The Service determines that the circumstances resulting in the
ineffectiveness or termination were inadvertent; (C) Steps were taken by the corporation
to qualify it as a small business corporation within a reasonable period of time after
discovery of the ineffectiveness or termination event; and (D) The corporation and all
shareholders agree to any adjustments that the Service may require for the period.
CONCLUSION

Based on the facts submitted and representations made, we conclude that the
ineffectiveness of X's S election, as a result of Agreement 1, Agreement 2, and
PLR-105657-22                                 4

Agreement 3 creating a second class of stock, was inadvertent within the meaning of
§ 1362(f). Accordingly, under § 1362(f), X will be treated as an S corporation from Date
2, and thereafter, provided the S election for X is otherwise valid and has not terminated
under § 1362(d).

Except as specifically ruled above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provisions of
the Code. Specifically, we express or imply no opinion as to whether X was otherwise
eligible to be treated 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.

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

In accordance with a power of attorney on file with this office, we are sending a copy of
this letter to X's authorized representatives.

                                       Sincerely,


                                       _________________________
                                       Joy C. Spies
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs and Special Industries)

Enclosure:
      Copy of this letter for § 6110 purposes




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