Business keeps S status despite second-class-of-stock problems

Plain-English summary

A state-law limited partnership elected corporate and S corporation tax treatment, but its partnership agreement contained provisions that created a second class of stock for federal tax purposes. The business also made disproportionate distributions and approved a credit facility that permitted non-identical distributions. After learning that these arrangements threatened its S status, it reorganized, amended the governing agreements to require identical rights, removed the credit facility provisions, and made true-up payments. The IRS found the ineffective election caused by the agreement inadvertent. It also ruled that any ineffectiveness from the state-law partnership form, and any termination caused by the credit facility's approved distributions, were inadvertent, allowing S treatment to continue from the intended effective date.

Ruling snapshot

• Question: May the business retain S status despite governing provisions and distribution rights that created a second class of stock?
• Outcome: Approved, the ineffectiveness and any described termination were inadvertent
• Key authorities: IRC §§ 1361(b), 1362(f); Treas. Reg. § 1.1361-1(l)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202447001 Third Party Communication: None
Release Date: 11/22/2024 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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------------------------------------- Telephone Number:
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--------------------------------- Refer Reply To:
CC:PSI:B03
PLR-100877-24
Date:
July 18, 2024

LEGEND

Company = --------------------------------------------
-----------------------

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

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

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

Y = ------------------------------

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

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

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

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

Date 5 = --------------------------

Date 6 = --------------------------

Agreement = ----------------------------------------------
----------------------------------------------
-------------- -------------

State = --------
PLR-100877-24 2

Year 1 = -------

Year 2 = -------

Year 3 = -------

Dear :

  This letter responds to a letter dated December 21, 2023, and subsequent

correspondence, submitted on behalf of Company by its authorized representatives,
requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                      FACTS

   The information submitted states that Company was formed as a limited

partnership under the laws of State on Date 1. At formation Company was wholly owned
by A, directly and indirectly through X, a State limited liability company wholly owned
solely by A which was treated as a disregarded entity for federal tax purposes. Under
the laws of State, interests in Company and X were owned as community property by A
and B.

    Also on Date 1, A and X signed a limited partnership agreement for

Company, Agreement, which included provisions in contemplation of Company being
treated as a partnership for federal income tax purposes.
Specifically, Agreement included the establishment and maintenance of capital
accounts as provided in Treasury regulations, referenced defined terms under
subchapter K of the Code, and provided for liquidation proceeds to be distributed in
accordance with positive capital account balances. However, it also provided that
distributions and all items of income, gain, loss, and deduction were to be made pro
rata. Agreement also conferred on X as the general partner broad authority, including
the power to alter the owners’ rights to distributions. On Date 3, Company filed Form
8832, Entity Classification Election, electing to be treated as a corporation for federal
income tax purposes, effective Date 2. On Date 4, Company filed Form 2553, Election
by a Small Business Corporation, electing to be treated as an S corporation,
effective Date 2. However, on Date 2 and Date 4, Agreement was still in effect and
Company remained a limited partnership under the laws of State.
PLR-100877-24 3

    Beginning in Year 1 and in subsequent years, A transferred to B certain limited

partnership interests in Company, which were then held by B as separate property
under the laws of State. From Year 1 to Year 2, Company made distributions solely to
A, notwithstanding B’s partial ownership of Company as separate property. Company
also had in place a senior credit facility, which permitted Company to borrow money to
make non-identical distributions for the purpose of paying salary, life insurance
premiums, and accrued interest. In Year 3, X, as Company’s general partner, approved
distributions pursuant to the senior credit facility. However, all actual distributions in
Year 3 were made pro rata.

    Company was subsequently advised that the provisions of Agreement, the

disproportionate distributions to A and B, its formation under state law as a limited
partnership, and the approval of distributions under the senior credit facility rendered
Company’s S Corporation election invalid or otherwise terminated. Company then took
the following remedial actions. On Date 5, Company engaged in a reorganization, which
resulted in Company being wholly owned for federal income tax purposes by Y, a newly
formed State limited liability company that elected to be treated as a corporation for
federal tax purposes (the “Reorganization”). Y purported to succeed to Company’s S
corporation election, which then filed an election to treat Company as a qualified
subchapter S corporation, effective Date 5. Y’s limited liability company agreement
confers identical distribution and liquidation rights on its owners and does not reference
any provisions of subchapter K of the Code.

   To further remediate the issues that caused the ineffectiveness (or termination)

of Company’s S election, Company amended Agreement to eliminate all references to
subchapter K of the Code and to confer identical distribution and liquidation rights on its
owners. The terms of the senior credit facility were also amended to eliminate any rights
to non-identical distributions. Finally, on Date 6, A made certain true-up payments to B
in amounts designed to correct the disproportionate distributions to A that occurred
between Year 1 to Year 2.

   The information provided states that on and after Date 2, the owners of Company

were all eligible S Corporation shareholders, all income and expense items were
allocated on a pro rata basis, and other than described above, all distributions were
made on a pro-rata basis based on ownership, and all shareholders were treated
equally in corporate matters. Company represents that the ineffectiveness or
termination of Company’s S corporation election was inadvertent and not motivated by
tax avoidance or retroactive tax planning. Company and its shareholders agree to make
any adjustments (consistent with the treatment of Company as an S corporation) as
may be required by the Secretary.
PLR-100877-24 4

                               LAW AND ANALYSIS

   Section 1361(a)(1) of the Code 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) 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(a)(1) 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 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 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) or to obtain shareholder consents or was terminated under §
1362(d)(2), (2) the Secretary determines that the circumstances resulting in such
ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of
time after discovery of the circumstances resulting in such 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 or to acquire the required
shareholder consents, 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 specified pursuant to § 1362(f), agrees to make the
adjustments (consistent with the treatment of such corporation as an S corporation) as
PLR-100877-24 5

may be required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in such ineffectiveness or termination, such corporation shall 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

Company’s S corporation election was ineffective on Date 2 as a result of Agreement
creating a second class of stock. We also conclude that the ineffectiveness of
Company’s S election, due to Agreement creating a second class of stock, was
inadvertent within the meaning of § 1362(f). We further conclude that if Company’s S
election was ineffective due to Company’s status as a State limited partnership on Date
2 creating a second class of stock, such ineffectiveness was inadvertent within the
meaning of § 1362(f). Finally, we conclude that if the approval of distributions under the
senior credit facility caused a termination of Company’s S election in Year 3, due to
creating a second class of stock, such termination was inadvertent within the meaning
of § 1362(f).

   Accordingly, under § 1362(f), Company will be treated as continuing to be an S

corporation on and after Date 2, provided that Company’s S corporation election was
valid and not otherwise terminated under § 1362(d).

   Except as specifically ruled above, we express or imply no opinion as to the

federal income tax consequences of the facts described above under any other
provision of the Code, including Company’s eligibility to be a valid S corporation or the
Reorganization.

  This ruling is directed only to the taxpayer who requested it. According to §

6110(k)(3), this ruling may not be used or cited as precedent.

    Pursuant to the power of attorney on file with this office, we are sending a copy of

this letter to your authorized representatives.

                                    Sincerely,


                                                 /s/

                                    Robert D. Alinsky
                                    Branch Chief, Branch 3
                                    Office of the Associate Chief
                                    Counsel (Passthroughs & Special
                                    Industries)

PLR-100877-24 6

Enclosure:
Copy of this letter for § 6110 purposes

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