S status restored after second stock class

Plain-English summary

An S corporation's operating agreement gave shareholders different rights to distributions and liquidation proceeds by allocating amounts through capital accounts before using ownership percentages. Those binding provisions created more than one class of stock and terminated the company's S election. The company also made disproportionate distributions over three years, but later amended its operating agreement to eliminate the offending provisions. The IRS found the termination inadvertent and allowed S status to continue from the termination date. Relief is conditional on corrective distributions that eliminate the cumulative disproportionate amounts paid to shareholders.

Ruling snapshot

• Question: Could the company retain S status after its operating agreement created a second class of stock?
• Outcome: Approved, subject to corrective shareholder distributions
• Key authorities: IRC §§ 1361(b)(1)(D), 1362(d), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 202344004                                              Third Party Communication: None
Release Date: 11/3/2023                                        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-102687-23
--                                                             Date:
                                                               August 03, 2023




                                                   LEGEND

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

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

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

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

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

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

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

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

Year1              = -------

Year2              = -------

Year3              = -------

                                            2

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



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

This letter responds to a letter dated February 1, 2023, submitted on behalf of X by X’s
authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code (Code).

                                         FACTS

According to the information submitted, X is a limited liability company organized under
the laws of State on Date1. X filed an election to be treated as an S corporation
pursuant to IRC Section 1362(a), to be effective Date2.

On Date3, A and B executed Agreement1, and X simultaneously issued shares of X to
B. The terms of Agreement1 did not provide for identical rights to distribution and
liquidation proceeds. Specifically, Agreement1 contained partnership provisions such
as, in Section 10.4 of the agreement, that distributions would be provided to members
“in proportion to their capital accounts, until all capital accounts had been reduced to
zero.” Only after this step were proceeds distributed to members in accordance with
their respective percentages of membership interest. Article 14 further provides for, in
the case of a liquidation of the taxpayer, property first be distributed to the members in
accordance with their capital account balance. These provisions of Agreement1 caused
X to have more than one class of stock under § 1361(b)(1)(D), and therefore terminated
X’s S election as of Date3. X also made disproportionate distributions to A and B during
Year1, Year2, and Year3.

X represents that it executed an amended operating agreement (Agreement2) that
eliminated the provisions that caused X to have more than one class of stock.

X represents that the circumstances surrounding the termination of X’s S corporation
election were inadvertent and not the result of tax avoidance or retroactive tax planning.
X further represents that for each taxable year beginning Date2, X and its shareholders
have filed consistently with X being an S corporation. In addition, X and its
shareholders agree to make any adjustments that may be required by the Secretary as
a condition of obtaining relief under § 1362(f).

                                   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

PLR-102687-23                                 3

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) of the Income Tax Regulations 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 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 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.

PLR-102687-23                                 4

                                      CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated as of Date3 because X had more than one class
of stock. We conclude, however, that the circumstances that caused this S election to
terminate were inadvertent within the meaning of § 1362(f). Therefore, under § 1362(f),
X will be treated as an S corporation Date3 and thereafter, provided that its S
corporation election was otherwise valid and has not otherwise terminated under
§ 1362(d).

This ruling is contingent on X taking remedial steps to make corrective distributions to its
shareholders to eliminate the cumulative amount of the disproportionate distributions made
by X to its shareholders.

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 was or is otherwise
eligible to be an S corporation.

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 ruling request, it is subject to verification on examination.

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

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


                                       Sincerely,



                                       Caroline E. Hay
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)




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