A Second Class of Stock May Not Jeopardize Your S Election

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Zachary J. Montgomery

Zachary J. Montgomery

Attorney

469.998.8484
zmontgomery@freemanlaw.com

Zachary J. Montgomery is a dual-credentialed attorney and CPA. He practices in the area of federal and state tax litigation, white-collar defense, business and tax planning, and litigation. Mr. Montgomery has experience representing both businesses and individuals in federal tax controversies, including appeals, examinations, penalty abatement and collection matters. He has also represented taxpayers—from small organizations to Fortune 500 companies—with Texas franchise tax refund claims, audits, penalty abatement, and corporate structuring.

Mr. Montgomery is a graduate of the University of Virginia School of Law where he focused his studies on corporate and tax law and served on the editorial board of the Virginia Tax Review. Prior to joining the firm, he gained experience with PricewaterhouseCoopers, LLP, and a regional firm, focusing on federal and state tax controversies. His previous experience also includes Ernst & Young, Deloitte & Touche, and a judicial student clerkship with the First Court of Appeals of Texas.

Mr. Montgomery is a graduate of Texas A&M University, where he graduated Summa Cum Laude and received his B.B.A. with a double major in Accounting and Business Honors and his M.S. in Management Information Systems. While attending Texas A&M, he developed his business acumen, working as an enterprise risk consultant and financial analyst.

On Christmas Eve, while Santa was packing up his sleigh, the Internal Revenue Service (“IRS”) released a Private Letter Ruling related to S election status. As noted in a previous Insight Blog, corporations may jeopardize their S election by failing to timely submit Form 2553, failing to obtain spousal consent, or, in this case, creating a second class of stock. Here, however, despite the creation of a second class of stock, the IRS determined that the termination of the taxpayer’s S election was inadvertent and, therefore, still valid.

S Election Terminations, Generally

Generally, a small business corporation may terminate its S election in a number of manners.[1] For example, a majority of the corporation’s shareholders may elect to voluntarily revoke the election.[2] Further, a corporation may cease to be a small business corporation (e.g., having more than 100 shareholders) or the corporation’s passive investment income may exceed 25 percent of gross receipts for three consecutive taxable years and the corporation has accumulated earnings and profits.[3]

Section 1362(d)(2)(A) and 1361(b)(1) describe the circumstances in which a corporation ceases to be a small business corporation:

(2) By corporation ceasing to be a small business corporation

(A) In general

An election under subsection (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 1361(b)(1) defines the term “small business corporation”:

(1) In general

For purposes of this subchapter, the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not—

Section 1362(f) describes inadvertent invalid elections or terminations. If a corporation’s S election status is terminated under Section 1362(d)(2)(A),

(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—

then, notwithstanding the circumstances resulting in such ineffectiveness or termination, such corporation shall be treated as an S corporation or a qualified subchapter S subsidiary, as the case may be, during the period specified by the Secretary.

Private Letter Ruling 202045006

On December 24, 2020, the IRS issued a Private Letter Ruling (“PLR”) related to a taxpayer’s request for a ruling under Section 1362(f).[4] The PLR states in part:

The information submitted states Company was organized on Date 1 as a limited liability company under the laws of State and elected to be an S corporation effective Date 2. On Date 3, an operating agreement, Agreement 1, was executed and included provisions in contemplation of Company being treated as a partnership for federal income tax purposes; however, the applicability of those provisions was not limited to such a situation.[5]

. . .

Company represents that since Date 2Company and its shareholders have filed all tax returns consistent with Company having a valid S corporation in effect as of Date 2Company also represents that since Date 2, all distributions were made to the shareholders based on their pro rata shares of ownership of CompanyCompany represents that entering into Agreement 1 created a second class of stock, causing its S corporation status to terminate. Company represents that, on Date 4Agreement 2 replaced Agreement 1, in part, to eliminate the potential for a second class of stock under §1361(b)(1)(D). Company represents that the termination of Company‘s S corporation election was inadvertent and not motivated by tax avoidance. Company and each person who has been a shareholder of Company at any time on or after Date 1 through the date of this request have consented to any adjustments as may be required by the Secretary.[6]

Conclusion

Notably, the Internal Service Revenue concluded that the termination of the taxpayer’s S election as a result of Agreement 1 creating a second class of stock was inadvertent within the meaning of Section 1362(f). Consequently, the IRS held that the taxpayer’s S election was valid from the date the corporation originally made its S election to present, assuming the S election was otherwise valid and not terminated under Section 1362(d).

Here, the taxpayer received a favorable determination from the IRS. However, it should be noted that the PLR did not disclose the amount of time that lapsed between the date Agreement 1 was executed and the date Agreement 2 replaced Agreement 1—the IRS apparently determined that it was a “reasonable period of time” within the meaning of Section 1362(f)(3). Regardless, taxpayers should be mindful that certain corporate actions may jeopardize their S election status. The onus is on the taxpayer to quickly discover and remedy an inadvertent termination.

 

[1] See I.R.C. § 1362(d).

[2] See I.R.C. § 1362(d)(1).

[3] See I.R.C. § 1362(d)(2)-(3).

[4] I.R.S. Priv. Ltr. Rul. 202052003 (Dec. 24, 2020).

[5] Id. Agreement 1 incorporated certain provisions, such as the distribution of capital proceeds and the allocation of profit/loss from capital transactions.

[6] Id.

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