The IRS held in a private letter ruling (PLR 202010001
) that a taxpayer’s election to be treated as an S corporation was ineffective because the company had more than one class of stock as of the intended effective date of the S election. The ruling also stated that even if the initial S election had been effective, such election would have terminated when the company issued equity to an ineligible shareholder. The IRS held, however, that the initial ineffective S election and subsequent termination of such election were both inadvertent and granted relief to the company.
In the facts of the ruling, the company was originally formed as a limited liability company (LLC). The IRS noted that the company contemplated operating as a partnership for federal income tax purposes, and that its operating agreement included provisions regarding special non-pro rata allocations of income, losses and distributions typical of a partnership, but that violated the S corporation single class of stock rules. For example, the company’s operating agreement provided a provision requiring, in part, “Upon the dissolution of the Company, the Members shall proceed to liquidate the Company and the liquidation proceeds will be applied and distributed in the following order of priority … to the Members in proportion to their respective positive Capital Accounts.”
In addition, the IRS noted that on a date after formation, the company issued equity to an individual retirement account (IRA), which was an ineligible S corporation shareholder. The company repurchased the equity held by the IRA at later date and before requesting the private letter ruling, but apparently had not amended its operating agreement at the time of the request.
The company sought relief from the IRS under Section 1362(f) and requested two rulings. Specifically, the company requested relief because its governing provisions created more than one class of stock and because it issued equity to an ineligible shareholder.
The IRS first concluded that the initial intended S election was, in fact, ineffective due because the company’s operating agreement created more than one class of stock. It next concluded that had the company’s S corporation election otherwise been effective, the election would have terminated when the company issued shares to an IRA, an ineligible S corporation shareholder. The IRS then ruled that both were inadvertent under Section 1362(f). Accordingly, the company was granted relief to be treated as an S corporation, subject to certain conditions, including that company amend its operating agreement so that it would only have one class of stock.
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