Inadvertent S corporation election defects excused

Plain-English summary

A limited liability company elected S corporation status, but its election was ineffective from the start for two reasons. A corporate owner was treated as holding an interest on the effective date, and the company's operating agreement gave owners nonidentical distribution and liquidation rights. After discovering the defects, the company amended the agreement and represented that it and its shareholders had consistently filed as an S corporation. The IRS found the failures inadvertent under section 1362(f) and ruled that the company would be treated as an S corporation from the intended effective date forward. The relief depends on the election being otherwise valid and not otherwise terminated.

Ruling snapshot

• Question: May the company retain S corporation treatment despite an ineligible shareholder and a governing agreement that created a second class of stock?
• Outcome: Approved as inadvertent election ineffectiveness
• Key authorities: IRC §§ 1361, 1362(f), and 1377; Treas. Reg. §§ 1.1361-1 and 1.1377-1

Full text (IRS public release)

Internal Revenue Service                                         Department of the Treasury
                                                                 Washington, DC 20224

Number: 202347006                                                Third Party Communication: None
Release Date: 11/24/2023                                         Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                                 Person To Contact:
----------------                                                 ----------------------, ID No. -----------------
--------------------------------                                 Telephone Number:
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-------------                                                    Refer Reply To:
-----------------------------                                    CC:PSI:B03
----------------------------------                               PLR-104401-23
                                                                 Date:
                                                                 August 28, 2023




    Legend

X           = -------------------------------------------------------------------------------------------------------
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Y           = -------------------------------------------------------------------------------------------------------
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A           = ----------------------

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

State       = --------

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

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



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

           This letter responds to a letter dated February 27, 2023, and subsequent
    correspondence, submitted on behalf of X, requesting a ruling under § 1362(f) of the
    Internal Revenue Code (Code).
PLR-104401-23                                 2

                                          FACTS

        According to the information submitted, X, a State limited liability company,
 elected to be an S corporation effective Date 1. Y, an association taxable as a
 corporation for federal tax purposes, owned an interest in X. On Date 1, Y liquidated
 and transferred its interest in X to individuals, A and B. Under § 1.1377-1(a)(2)(ii) of
 the Income Tax Regulations, Y was treated as a shareholder of X on Date 1. Because
 Y was an ineligible S corporation shareholder under § 1361(b)(1)(B), X’s S corporation
 election was ineffective on Date 1.

       Additionally, X’s operating agreement, effective Date 1, contained terms causing
X to have more than one class of stock under § 1361(b)(1)(D). The agreement failed to
provide for identical distribution and liquidation rights. During Date 2, X learned that its
S corporation election was ineffective on Date 1. Subsequently, on Date 3, X amended
its operating agreement to reflect its intent to be treated as an S corporation and to
provide that all shares of its stock confer identical rights to distribution and liquidation
proceeds.

         X 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. Additionally, X represents that X and its shareholders have
filed all federal tax returns consistent with X’s status as an S corporation. Finally, X and
its shareholders have agreed to make any adjustments (consistent with the treatment of
X as an S corporation) 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 such 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,
PLR-104401-23                                3

applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, governing provisions).

      Section 1362(a) provides that a small business corporation may elect to be an S
corporation.

       Section 1362(d)(2)(A) provides that an election under § 1362(a) will 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 relevant part, that if (1) an election under § 1362(a)
by any corporation 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); (2) the Secretary determines that the circumstances resulting in the
ineffectiveness were inadvertent; (3) no later than a reasonable period of time after
discovery of the circumstances resulting in the ineffectiveness, steps were taken so that
the corporation for which the election was made is a small business corporation; and
(4) the corporation for which the election was made, and each person who was a
shareholder of the corporation at any time during the period specified under § 1362(f),
agrees to make the adjustments (consistent with the treatment of the corporation as an
S corporation) as may be required by the Secretary for that period, then,
notwithstanding the circumstances resulting in such ineffectiveness, the corporation will
be treated as an S corporation during the period specified by the Secretary.

                                     CONCLUSION

        Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election was ineffective on Date 1 because, on Date 1, X had an
ineligible shareholder under § 1361(b)(1)(B) and had more than one class of stock
under § 1361(b)(1)(D). We conclude, however, that the circumstances resulting in the
ineffectiveness were inadvertent within the meaning of § 1362(f). Therefore, under
§ 1362(f), X will be treated as an S corporation from Date 1 and thereafter, provided that
X’s S corporation election was valid and has 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 of this case under any other
provision of the Code and the regulations thereunder. Specifically, we express or imply
no opinion regarding 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.
PLR-104401-23                                            4


       This ruling is directed only to the taxpayer who 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,


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


Enclosure
      Copy of this letter for § 6110 purposes



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