An LLC's S election was invalid because its operating agreement created a second class of stock, but the defect was inadvertent, so S status is preserved

Plain-English summary

An LLC that had been taxed as a partnership elected to become an S corporation. To
qualify as an S corporation, a company can have only "one class of stock," meaning
all owners get identical rights to distributions and liquidation proceeds. This
LLC's operating agreement still contained partnership-style provisions: extra
compensation for capital contributions beyond the ownership ratio, and liquidation
payouts tied to each member's capital account balance. Those provisions gave the
owners non-identical rights, which counts as a second class of stock and quietly
made the S election invalid from the start. The LLC also made distributions to its
two owners that were not proportional to ownership. The company later amended the
agreement to remove the offending provisions and made a corrective distribution to
even things out. It asked the IRS for relief under Section 1362(f), which lets the
IRS overlook an invalid S election when the problem was inadvertent, was fixed
within a reasonable time, and the owners agree to any required adjustments. The IRS
found the defect inadvertent and ruled the LLC is treated as an S corporation from
the intended effective date onward.

Ruling snapshot

• Question: Was the LLC's invalid S election (caused by a second class of stock in its operating agreement) inadvertent, so that S corporation status can be preserved?
• Outcome: Approved (inadvertent invalidity relief granted under § 1362(f))
• Key authorities: IRC § 1361(b)(1)(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: 202551033                               Third Party Communication: None
Release Date: 12/19/2025                        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-105215-25
                                                Date:
                                                July 25, 2025


                                                  LEGEND

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

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

B                   = ------------------------
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Agreement 1         = ----------------------------------------------------------------------------------------------
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Agreement 2         = ----------------------------------------------------------------------------------------------
                      -------------------------------------------

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

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

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

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

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

State               =

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

This letter responds to a letter dated February 6, 2025, submitted on behalf of X by X's
authorized representatives, 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 Date 1. For federal tax purposes, X was treated as a partnership
from Date 1 through Date 2. X filed an election to be treated as an S corporation
pursuant to § 1362(a) of the Code, effective Date3.

On Date1, A and B executed Agreement 1 and became shareholders of X. The terms of
Agreement 1 did not provide for identical rights to distribution and liquidation proceeds.
Agreement 1 provided that "[m]embers are entitled to interest or other compensation for
or on account of their capital contributions to [X] that exceed the ownership ratio
established in Schedule 2 of this document." Additionally, Agreement 1 contained
partnership provisions, including a requirement that "[d]istributions in liquidation of [X] or
in liquidation of a Member's interest shall be made in accordance with the positive
capital account balances pursuant to" § 1.704-1(b)(2)(ii)(b)(2)." Furthermore, Agreement
1 provided that upon the winding up of X, the remaining liquidation proceeds were
distributable "[t]o Members in the amount of their respective adjusted Capital Account
balances on the date of the distribution." These provisions of Agreement 1 caused X to
have more than one class of stock under § 1361(b)(1)(D), and therefore X's S
corporation election intended to be effective Date 3 was ineffective. X also made
disproportionate distributions to A and B after Date 3.

X represents that it executed an amended operating agreement (Agreement 2) on
Date 4 that eliminated the provisions that caused X to have more than one class of
stock. X also represents that, on Date 5, X made a corrective distribution to B that
brought the aggregate distributions to X's shareholders into the same proportion as their
ownership interests.

X represents that the circumstances surrounding the ineffectiveness 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 Date 3, 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
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(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.

                                     CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X's S corporation election was ineffective on Date 3 because X had more than one
class of stock. We further conclude, however, that the circumstances that caused this S
election to be ineffective were inadvertent within the meaning of § 1362(f). Therefore,
under § 1362(f), X will be treated as being an S corporation beginning Date 3 and
thereafter, provided that its S corporation election was otherwise valid and has not
otherwise terminated under § 1362(d).

Except as specifically ruled 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 representatives.


                                                Sincerely,



                                                Joy C. Spies
                                                Senior Technician Reviewer, Branch 1
                                                Office of the Associate Chief Counsel
                                                (Passthroughs, Trusts, and Estates)

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