S election with missing shareholder consents and a second class of stock gets inadvertent-termination relief

Plain-English summary

An LLC (called X) elected to be taxed as an S corporation, but its election was defective from the start because it never collected all the shareholder consents that Form 2553 requires. On top of that, its operating agreement created three classes of equity, and an S corporation may have only one class of stock, so the election also would have terminated when a new investor bought in. The company later replaced that agreement with one that reclassified everything into a single class of units sharing distributions and liquidation proceeds by ownership percentage. It asked the IRS for relief under section 1362(f), which lets the IRS forgive an S election that was inadvertently invalid or terminated. The IRS agreed that both defects, the missing consents and the second class of stock, were inadvertent and not driven by tax avoidance, and that the company had otherwise qualified and filed as an S corporation throughout. It granted relief: X is treated as an S corporation from the relevant date forward, provided the election is otherwise valid and has not terminated for some other reason. As a condition, any shareholder who never signed the original Form 2553 must file a written consent within 120 days. This is a routine cure for two common S-corp traps: incomplete consents and an operating agreement that accidentally creates a second class of stock.

Ruling snapshot

• Question: Should the IRS grant § 1362(f) relief for an S election that was ineffective (missing shareholder consents) and would have terminated (a second class of stock)?
• Outcome: Approved (inadvertent invalid election and inadvertent termination; conditioned on filing the missing consents within 120 days)
• Key authorities: IRC §§ 1362(f), 1362(a), 1361(b), 1362(d)(2); Treas. Reg. §§ 1.1361-1(l), 1.1362-6

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 202322004                                            Third Party Communication: None
Release Date: 6/2/2023                                       Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-01,
              1362.04-00                                     Person To Contact:
                                                             ------------------------, ID No. -----------------
---------------------------------                            Telephone Number:
-----------------------------------------------------        --------------------
----------------------                                       Refer Reply To:
-----------------------------                                CC:PSI:01
--------------------------                                   PLR-116711-22
                                                             Date:
                                                             March 01, 2023

                                                  LEGEND

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

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

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

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

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

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

D                 = -------------------------------------------------------------------------------------------
                    -------------------------------------------------------------------------------------------
                    -------------------------------------------------------------------------------------------
E                 = ------------------------------------------

Date 1            = -------------------------------------------------------------------------------------------
                    -------------------------------------------------------------------------------------------
Date 2            = -------------------------

Date 3            = ----------------------
PLR-116711-22                                  2

 State                  ----------

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

This letter responds to a letter dated August 30, 2022, submitted on behalf of X by its
authorized representatives, requesting a ruling under § 1362(f) of the Internal Revenue
Code.
                                          FACTS

The information submitted states that X was organized on Date 1 as a limited liability
company under the laws of State. Effective Date 1, X filed Form 2553, Election by a Small
Business Corporation, for X to be treated as an S corporation. However, X represents that it
did not obtain all of the shareholder consents required by § 1.1362-6, resulting in an
ineffective election.

Prior to Date 2, X was wholly owned by spouses C and D through disregarded entities A
and B and had an operating agreement, Agreement 1. Agreement 1 provided for different
rights concerning distributions and liquidation proceeds. Specifically, Sections 4.2 through
4.5 of Agreement 1 provided that X would have three classes of equity. Sections 9.1, 9.4,
and 12.3 of Agreement 1 provided various details for the preferences, distributions, and
allocations that the holders of various units of stock would be entitled to. On Date 2, E
acquired shares of X. If X’s S election had not been ineffective, it would have terminated on
Date 2 due to a second class of stock created by the provisions of Agreement 1.

The provisions of Agreement 1 applied until Date 3, when Agreement 2 replaced Agreement

1. The provisions of Agreement 2 reclassified all units issued between Date 1 and Date 3
into a single class of units. Additionally, Agreement 2 did not include capital account
maintenance provisions and required that all distribution and liquidation proceeds be shared
in accordance with the shareholders’ ownership interests.

X represents that it intended to make a valid S corporation election effective Date 1 and that
the ineffectiveness of the election was inadvertent and not motivated by tax avoidance or
retroactive tax planning. X further represents that neither X nor its shareholders intended to
terminate X's Subchapter S election on Date 2 and that X and its shareholders have filed
consistently with being an S corporation. X represents that, other than the ineffectiveness
caused by the failure to submit consents from all required shareholders on the original Form
2553 and the termination caused by the provisions contained within Agreement 1, X has
qualified as a small business corporation at all times since its election effective Date 1. 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) that may be required by the Secretary.
PLR-116711-22                                   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 1362(a)(2) provides that an election to be treated as an S corporation shall be valid
only if all persons who are shareholders in such corporation on the day on which such
election is made consent to such election.

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) provides, in part, that if (1) an election under § 1362(a) by any corporation
was not effective for the taxable year made (determined without regard to § 1362(b)(2)) by
reason of failure to obtain shareholder consents, or 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 the
discovery of the circumstances resulting in the ineffectiveness or termination, steps were
taken so that the corporation for which the election was made or 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 in such corporation at any
time during the period of inadvertent ineffectiveness or termination of the S election, agrees
to makes 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 is treated as an S corporation during the period specified by the Secretary.
PLR-116711-22                                  4

                                          CONCLUSION

Based on the facts submitted and the representations made, we first conclude that X's S
corporation election was ineffective because the required shareholder consents to the
election were not obtained, and because of the provisions contained in Agreement 1.
However, we also conclude that the ineffectiveness of X's S corporation election was
inadvertent within the meaning of § 1362(f). We further conclude that, if X's election had not
been ineffective, it would have terminated on Date 2 because of the provisions found in
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 an S corporation from Date 2,
and thereafter, provided the S election for X otherwise is valid and has not terminated under
§ 1362(d).

As a condition of this ruling, any current or former shareholder of X required by § 1.1362-6
to sign X's Form 2553 that has not done so must sign a written statement as described in
§ 1.1362-6(b)(1) consenting to X's S election effective Date 1. The written statement(s)
must be filed with the appropriate service center within 120 days from the date of this letter,
indicating that the statement(s) are to be associated with X's originally filed Form 2553.

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 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 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 representative.

                                                       Sincerely,

                                                      /s/ Joy C. Spies
                                                       Joy C. Spies
                                                       Senior Technician Reviewer, Branch 1
                                                       (Passthroughs & Special Industries)

Enclosure (1)
Copy of this letter for § 6110 purposes

cc: