S corporation kept its status after fixing a second class of stock

Plain-English summary

An S corporation issued stock to a second shareholder, and the shareholders signed an agreement that allowed unequal rights to distributions and liquidation proceeds. That binding agreement created a prohibited second class of stock and terminated the corporation's S election. After discovering the problem, the shareholders replaced the agreement with one that did not create a second class of stock. The corporation and its shareholders had filed consistently with S corporation treatment, represented that the termination was inadvertent, and agreed to any required adjustments. The IRS granted relief under section 1362(f), treating the corporation as continuously eligible for S corporation status from the termination date, assuming no other defect invalidated or terminated the election.

Ruling snapshot

• Question: Could the corporation receive inadvertent-termination relief after a shareholder agreement created unequal distribution and liquidation rights?
• Outcome: approved (continuous S corporation treatment)
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d)(2), 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: 202251005                                              Third Party Communication: None
 Release Date: 12/23/2022                                       Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.02-00
                                                                Person To Contact:
 -----------------------------                                  ----------------------, ID No. -----------------
 ---------------------------------                              Telephone Number:
 ----------------------------------                             --------------------
 --------------------------                                     Refer Reply To:
 ------------------------------------------------------------   CC:PSI:B01
 ---------                                                      PLR-107976-22
                                                                Date:
                                                                September 26, 2022




Legend

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

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

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

Agreement1 =              ----------------------------------------------------------------

Agreement2 =              ------------------------------------------------------------

Date1            =        --------------------

Date2            =        ----------------------

Date3            =        ----------------------

Date4            =        -----------------

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


Dear ------------:
PLR-107976-22                                2

This letter responds to a letter dated April 12, 2022, submitted on behalf of X by its
authorized representatives, requesting relief under § 1362(f) of the Internal Revenue
Code (Code).

                                          FACTS

According to the information submitted and representations within, X was incorporated
under the laws of State on Date1. X filed an election under § 1362(a) of the Code to be
treated as an S corporation effective Date1.

Prior to Date2, A was the sole shareholder of X. On Date2, pursuant to a stock
purchase agreement, X issued shares of X stock to B such that A and B were equal
shareholders of X. Also on Date2, A and B executed Agreement1. X represents that
Agreement1 is a binding agreement relating to distribution and liquidation proceeds of
X. The terms of Agreement1 permitted X to make distributions to A and B in a manner
such that each outstanding share of X stock did not confer identical rights to distribution
and liquidation proceeds during the time period between Date2 and Date3. As a result,
Agreement1 created a second class of stock withing the meaning of § 1361(b)(1)(D)
and X’s S corporation election terminated on Date2.

X requests relief pursuant to § 1362(f) due to its governing provisions creating more
than one class of stock. X represents that upon discovery of its error, it promptly took
remedial action. On Date4, A and B executed Agreement2 which supersedes
Agreement1. X represents that no provision within Agreement2 causes X to be treated
as having more than one class of stock for purposes of § 1361(b)(1)(D).

X represents that X and its shareholders have filed tax returns consistent with being an
S corporation for all relevant periods. X further represents that the circumstances
resulting in the termination of its S corporation election were inadvertent and were not
motivated by tax avoidance or retroactive tax planning. 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 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
PLR-107976-22                                3

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 X's S
corporation election terminated on Date2 because Agreement1 created a second class
of stock. We further conclude that the circumstances resulting in the termination of X’s S
corporation election were inadvertent within the meaning of § 1362(f). Accordingly,
pursuant to the provisions of § 1362(f), we rule that X will be treated as continuing to be
an S corporation from Date2 and thereafter, provided that the S corporation election for
X otherwise is valid and has not terminated under § 1362(d) for reasons not addressed
in this letter.

The rulings contained in this letter are 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 request for rulings, it is subject to verification on examination.
PLR-107976-22                                4


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 whether X was otherwise a valid S corporation.

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

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


                                      Sincerely,



                                      Jennifer N. Keeney
                                      Senior Counsel, Branch 1
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)


Enclosure
Copy for § 6110 purposes



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