LLC received inadvertent invalid S election relief

Plain-English summary

An LLC elected corporate status and then S corporation status, but provisions in its operating agreement inadvertently created a second class of stock. The company also made disproportionate distributions and did not allocate tax items proportionately among its shareholders. After adopting a new operating agreement, the company represented that it would make corrective distributions and that it and its shareholders would accept required adjustments. The IRS treated the invalid S election as effective from its intended date, provided the election was otherwise valid and the corrective steps were completed.

Ruling snapshot

• Question: Could the LLC's S corporation election remain effective despite operating agreement provisions that created a second class of stock?
• Outcome: approved
• Key authorities: IRC §§ 1361, 1362, 1366, 1367, 1368; Treas. Reg. § 1.1361-1

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202422006                                              Third Party Communication: None
 Release Date: 5/31/2024                                        Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.01-00
                                                                Person To Contact:
 -------------------------------------                          ----------------------, ID No. -----------------
 ------------------------------------------------------------   Telephone Number:
 ----------------                                               --------------------
 -------------------------------------                          Refer Reply To:
 ------------------------------------                           CC:PSI:B03
 -------------------------                                      PLR-117063-23
 -------------------------------                                Date:
                                                                March 01, 2024




LEGEND

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

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

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

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

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

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

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

 Year 1               = -------

 Year 2               = -------

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

        This letter responds to a letter dated August 24, 2023 and subsequent
correspondence, submitted on behalf of X by its authorized representative, requesting
relief under § 1362(f) of the Internal Revenue Code (Code).
PLR-117063-23                                 2

                                          FACTS

       The information submitted states that X was formed as a limited liability company
organized under the laws of State on Date 1. X filed Form 8832, Entity Classification
Election, to be classified as an association taxable as a corporation effective Date 1. X’s
operating agreement, Agreement 1 effective Date 1, included provisions relevant to
treating X as a partnership for federal income tax purposes.

       Effective Date 2, X filed Form 2553, Election by a Small Business Corporation, for
X to be treated as an S corporation. X represents that certain provisions of Agreement 1
inadvertently created a second class of stock, causing its S election to be ineffective.

       From Year 1 to Year 2, X also made disproportionate distributions and did not
allocate its income and other tax items pro rata among its shareholders.

      X took corrective action by adopting a new operating agreement, Agreement 2, on
Date 3, which eliminated the provisions that caused X to have a second class of stock. X
represents it will make corrective distributions for the prior disproportionate distributions
made in Year 1 and through and including Year 2.

       X represents that the invalid S election was inadvertent and not motivated by tax
avoidance or retroactive tax planning. X also represents that X and its shareholders have
consistently treated X as an S corporation since Date 2 and agree 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) 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 1 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 whether all outstanding
shares of stock confer identical rights to distribution and liquidation proceeds is made
PLR-117063-23                                 3

based on the corporate charter, articles of incorporation, bylaws, applicable state law,
and binding agreements relating to distribution and liquidation proceeds (collectively, the
governing provisions).

       Section 1362(a)(1) provides that a small business corporation may elect to be an
S corporation. Section 1361(c) provides that an S election shall be effective for the taxable
year of the corporation for which it is made and for all succeeding taxable years of the
corporation, unless such election is terminated under § 1362(d).

      Section 1362(d)(2)(A) provides that an election under § 1362(a) terminates
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(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 solely on the facts submitted and representations made, we conclude that
the ineffectiveness of X’s S election on Date 2, as a result of Agreement 1 creating a
second class of stock 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 is otherwise valid and has not terminated under § 1362(d).

       Accordingly, X's shareholders, in determining their respective income tax liabilities,
must include their pro rata share of the separately stated and nonseparately computed
items of X as provided in § 1366, make any adjustments to stock basis as provided in
§ 1367, and take into account distributions made by X as provided by § 1368. As an
additional condition to this letter, X and its shareholders must take the steps as indicated
above to correct the possible terminating event. This ruling is contingent on X making
corrective distributions.

       Except as expressly provided herein, we express or imply no opinion concerning
the federal tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, no opinion is expressed or implied on whether X
was or is otherwise eligible to be treated as an S corporation.
PLR-117063-23                                    4

       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 request for ruling, 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.

       In accordance with the Power of Attorney on file with this office, a copy of this letter
is being sent to X’s authorized representatives.


                                           Sincerely,




                                           Robert D. Alinsky
                                           Branch Chief, Branch 3
                                           (Passthroughs & Special Industries)

Enclosure:
      Copy of this letter for § 6110 purposes


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