Editor: Greg A. Fairbanks, J.D., LL.M.
On June 1, 2018, the IRS released Letter Ruling 201822003, granting an LLC relief from an inadvertently terminated S election. The company’s operating agreement had created a second class of stock, making the company ineligible to be an S corporation. While the relief would generally be expected under the facts here, the letter ruling is unusual because it suggests that facts and circumstances outside the four corners of an S corporation’s governing provisions can be considered in determining if a second class of stock exists.
To understand the issue, a chronology of events is necessary. The redacted letter ruling provides that on date 1 a single-member LLC was formed with an operating agreement (Agreement 1) that provided for allocating the items of “profits, losses and distributions to Members in proportion to their relative Membership interests.” The LLC then made an S election effective date 2.
On date 3, Agreement 1 was replaced by Agreement 2. Agreement 2 provided for differing distribution and liquidation rights among units, based upon the member’s capital accounts that were computed using Secs. 754, 704(b), and 704(c).
Not until date 4 did a second shareholder acquire an interest in the S corporation. On date 5, Agreement 2 was replaced with Agreement 3, but Agreement 3 retained the same partnership provisions that affected the distribution and liquidation rights that appeared in Agreement 2.
On date 6, Agreement 3 was amended to create Agreement 4, which provided for identical distribution and liquidation rights to the shareholders.
The letter ruling provided for S election termination relief effective date 4, when the second shareholder was added to the S corporation. This is a unique interpretation, as the relief was not effective as of date 3 when Agreement 2 was in effect with the single shareholder. The letter ruling seems to imply that a wholly owned S corporation could not have more than one class of stock, regardless of the language in the corporation’s governing provisions. While it might stand to reason that if there is only one shareholder, then there can be only one class of stock, that is not necessarily what the Code and regulations provide, as discussed next.
The rules on determinations of a second class of stock
In general, an S corporation’s governing documents must provide for equal distribution and liquidation rights. Regs. Sec. 1.1361-1(l)(1) states:
[With certain exceptions], a corporation is 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.
The regulations then elaborate on how to analyze if there are identical distribution and liquidation rights. Regs. Sec. 1.1361-1(l)(2)(i) provides a general rule that the focus is on the corporation’s governing provisions:
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, the governing provisions).
The regulation defines “binding agreements relating to distribution and liquidation proceeds” to include only contracts that have a principal purpose to circumvent the one-class-of-stock requirement (id.). Note that there is no principal-purpose requirement for the corporate charter, articles of incorporation, bylaws, or applicable state law to create a second class of stock.
The regulations then provide four specific rules with respect to whether stock confers identical rights to distribution and liquidation proceeds when there is (1) a state law requirement for payment and withholding of income tax; (2) buy-sell and redemption agreements; (3) distributions that take into account varying interests in stock during a tax year; or (4) the special rule for Sec. 338(h)(10) elections.
Are there other exceptions not provided for in the regulations?
As noted earlier, the IRS seemed to imply in Letter Ruling 201822003 that if there is only one shareholder, there can be only one class of stock, regardless of the language in the corporation’s governing provisions. But is this consistent with the regulations? One relevant question to ask is what is meant by the “general rule” language in Regs. Sec. 1.1361-1(l)(2) (i) . Does the general rule of looking to the corporation’s governing provisions mean that the four exceptions specified in the regulations are the only four exceptions, or can other exceptions also be recognized?
First, we look to the actual language in the statute and the regulations. Then we look to the legislative history and subsequent history to provide any assistance in making this determination.
The plain language of the statute does not provide any help in interpreting what a single class of stock is, as no definition is provided. The plain language of Regs. Sec. 1.1361-1(l) (2) (i) is very specific in that the determination is “made based on” the governing provisions. The preamble to the regulations does not provide any insight into what is meant by “made based on.” Does this mean we can only look to the four corners of the governing provisions, or are we allowed to consider the actual facts and circumstances, too?
It appears from the regulations and recently issued Rev. Proc. 2022-19 (see the preceding item) that a fourcorners analysis of the governing documents is required, and no facts outside the governing documents should be considered. The regulations provide in Example 6 that a governing document modifying the normal per share distribution policy to allow for an adjustment to different state tax burdens was not allowed, even though it would have resulted in equal after-tax distribution rights (Regs. Sec. 1. 1361-1(l)(2)(vi)). (The inability to use facts outside the agreement may be the reason it was not allowed, but the reasoning is not explained.) It is also supported by the Service’s position in Rev. Proc. 2022-19, which states it will not treat any disproportionate distribution as violating the one-classof- stock requirement, so long as the governing provisions provide for identical distribution and liquidation rights among the shares of stock (see also id., Example 2).
The risk for taxpayers
The letter ruling seems to suggest that facts and circumstances outside the four corners of an S corporation’s governing provisions can be considered in determining if a second class of stock exists. Without more information from the government on whether, or when, facts and circumstances can be applied to a governing document analysis, there may be significant hazards for taxpayers.
It is important to highlight Rev. Proc. 2022-19, which allows taxpayers to self-correct nonidentical governing provisions if certain requirements can be met. It is likely the taxpayer in Letter Ruling 201822003 would be eligible for relief under Rev. Proc. 2022-19. That being said, it seems unlikely the government will grant letter ruling relief for second-class-of-stock issues if there is only one shareholder, leaving taxpayers potentially at risk if they cannot otherwise meet the requirements of Rev. Proc. 2022-19
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. Contributors are members of or associated with Grant Thornton LLP. For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.