Private Letter Ruling 202302004, 01/13/2023, IRC Sec. 1362
Summary: Entity “A” (“A”) was incorporated as a limited liability company under state law and thus was initially treated as a partnership for federal income tax purposes. However, “A” elected to be treated as an “S-corporation” (“S-corp”) by submitting an IRS Form 2553, Election by Small Business Corporation. “A” later participated in a reorganization under 26 U.S.C. § 368(f). In doing so, “A” elected to be treated as a “qualified subchapter S subsidiary,” pursuant to 26 U.S.C. § 1361(b)(3)(B), as “A” was wholly owned by Entity “B” (“B”). “B” (referred to herein as “Taxpayer-B”) was formed as a corporation and treated as an S-corporation for income tax purposes. “A” later elected to be treated as a disregarded entity from Taxpayer-B. The owners of Taxpayer-B entered into an Operating Agreement that included provisions where it was considered to treat the entity as a partnership (and not an S-corp) for federal income tax purposes but without limiting the company to that treatment, and the agreement included several partnership provisions. Taxpayer-B later adopted a Revised Operating Agreement but without modification to the previous partnership tax treatment provisions and without creating a second class of stock.
Key Issue: Whether, pursuant to 26 U.S.C. § 1362(f), Taxpayer-B may be treated as an S-corporation as of the date Taxpayer-B adopted the Operating Agreement?
Primary Holdings and Support: Yes, provided that Taxpayer-B’s S-corp election is valid and has not been terminated under 26 U.S.C. § 1362(d). Taxpayer-B’s declarations of tax treatment was not motivated by any retroactive tax planning or to avoid paying taxes. The shareholders of Taxpayer-B also agreed to make the adjustments required to obtain a relief under the inadvertent termination rule under § 1362(f), if and to the extent required by the IRS. Also, Taxpayer-B established that it submitted all applicable returns required for an S-corporation and that any second class of stock created by the initial Operating Agreement was also inadvertent. In sum, Taxpayer-B’s actions and evidence supported a finding that Taxpayer-B made an inadvertent selection of tax treatment.
Key Points of Law:
S-Corporations. The concept of “small business corporation” is defined as a domestic corporation, which is not an ineligible corporation (e.g. financial institution, insurance company, a DISC, among others) and does not: (1) have more than 100 shareholders, (2) have as a shareholder a person (other than an estate or trust (permitted as shareholders), or an exempt organization permitted as shareholders who is not an individual, (3) have a nonresident alien as a shareholder, and (4) have more than 1 class of stock. See § 26 U.S.C. 1361(b)(1).
Generally, a corporation may be considered to only have 1 class of stock if all the outstanding shares of the stock of the corporation grant identical rights to distribution and liquidation proceeds. See Treas. Reg. § 1.1361-1(l)(1).
A corporation which is a qualified subchapter S subsidiary, shall not be treated as a separate corporation, and all assets and liabilities, income, deduction, among other times, shall be treated as assets, liabilities, and other items of the S corporation. The corporate charter, articles of incorporation, bylaws, applicable state laws, and binding agreements relating to distribution and liquidation proceeds should be used to determine whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds. See Treas. Reg. § 1.1361-1(l)(2)(i).
S-Corp Election. Under 26 U.S.C. § 1362(a) a small business corporation may elect to be an S corporation, except as provided in § 1362(g). Additionally, the election is valid if the shareholders consent to such election on the day on which such election is made. If an S-corp election is made for any taxable year after the date prescribed to make the election and the IRS determines that there was a reasonable cause for the failure to timely make such election, the IRS may treat such election as timely made for the applicable taxable year. See § 1362(b)(5).
An election is effective for any taxable year until such election is terminated under subsection § 1362(d). An “S corporation” means a small business corporation for which an election under § 1362(a) is in effect for such tax year, regarding any taxable year. 26 U.S.C. § 1361(a)(1). An election to be an S-Corporation under § 1362(a) shall be terminated if, as of or after the first day of the corporation first taxable year as an S corporation, it terminates its small business corporation election. The termination shall be effective on and after the date of termination. See id. at § 1362(d)(2)(B).
Insights: This PLR provides some light for the taxpayers regarding corporate decisions that may have an impact on their tax elections, such as invalidating their tax election to be treated as an S-corporation, without having truly the purpose of terminating it, by, for example, creating a second class of shares. It is advisable to the shareholders to look for tax advice before making any corporate decisions, to determine if the intended course of action may have a tax implication on the company’s tax status or if such decisions may create non-tax compliance, as the tax election may be changed by the intended actions.
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