Partnership-style operating agreement does not end S status

Plain-English summary

An S corporation's operating agreement contained partnership provisions that allowed liquidation distributions based on members' capital interests or section 704 capital accounts. Those terms failed to provide identical distribution and liquidation rights and therefore created a prohibited second class of stock. The defect technically terminated the corporation's S election when the agreement took effect. After discovering the issue, the corporation amended and restated the agreement to remove the offending terms. The IRS found the termination inadvertent and treated the corporation as continuously maintaining S status, provided its election was otherwise valid and remained in effect.

Ruling snapshot

• Question: Can an S corporation preserve its election after partnership-style distribution provisions create a second class of stock?
• Outcome: Approved
• Key authorities: IRC §§ 1361(b), 1362(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: 202315005                                             Third Party Communication: None
 Release Date: 4/14/2023                                       Date of Communication: Not Applicable
 Index Numbers: 1362.00-00, 1362.04-00
                                                               Person To Contact:
 --------------------------                                    ------------, ID No. -----------------
 -----------------------------------------------------------   Telephone Number:
 --------------------------------------------------            --------------------
 ------------------------                                      Refer Reply To:
 ----------------------------------                            CC:PSI:B03
                                                               PLR-113905-22
                                                               Date:
                                                               January 17, 2023




LEGEND

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

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

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

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

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

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



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

       This letter responds to a letter dated July 12, 2022, submitted on behalf of X by
X’s 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 3, 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
for identical distribution and liquidation rights and applied irrespective of whether X was
PLR-113905-22                                 2

a partnership. For instance, the agreement required X to make liquidating distributions
in proportion to each member’s capital interest or capital account as computed under
§ 1.704-1(b)(2)(iv) of the Income Tax Regulations. Thus, X’s S corporation election
terminated on Date 3, the effective date of X’s operating agreement.

       X represents that once it learned that its S corporation election had terminated on
Date 3, it amended and restated its operating agreement, effective Date 4, to remove
the terms causing X to have more than one class of stock under § 1361(b)(1)(D).

       X represents that the circumstances resulting in the termination of its S
corporation election were inadvertent and not the result of retroactive tax planning or tax
avoidance. In addition, X represents that X and its shareholders have filed consistently
with X being an S corporation effective Date 3. In addition, X and its shareholders
agree to make any adjustments required as a condition of obtaining relief under
§ 1362(f) 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 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) 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
PLR-113905-22                                3

business corporation. Section 1362(d)(2)(B) further provides that the termination shall
be effective on and after the date of cessation.

       Section 1362(f) provides, in relevant 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 facts submitted and representations made, we conclude that X’s
S corporation election terminated on Date 3, as a result of X having more than one
class of stock. We conclude, however, that the circumstances resulting in the
termination of X’s S corporation election were inadvertent within the meaning of
§ 1362(f). Therefore, under § 1362(f), X will be treated as continuing to be an S
corporation from Date 3 and thereafter, provided that its S corporation election was valid
and 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.

      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.
PLR-113905-22                                            4

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

                                                Sincerely,


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


Enclosure:
      Copy of this letter for § 6110 purposes


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