IRS Grants Inadvertent Termination Relief for S Corporation with Multiple Classes of Stock

IRS Grants Relief for S Corporation’s Inadvertent Termination Due to Operating Agreement Flaws

The IRS granted relief under § 1362(f) to an S corporation whose election terminated after its operating agreement inadvertently created multiple classes of stock, allowing the corporation to retain its S status. The termination occurred when the agreement tied liquidating distribution rights to capital account balances under § 704(b), resulting in disproportionate economic rights among shareholders. The corporation also made disproportionate distributions prior to correction. While this ruling is non-precedential, it provides guidance for similarly situated taxpayers navigating operating agreement pitfalls.

Operating Agreement Provisions Triggered S Corporation Termination

The corporation, organized under State law on Date 1, initially elected S corporation status effective the same day. On Date 2, it adopted an operating agreement containing provisions that inadvertently created more than one class of stock under § 1361(b)(1)(D), which requires all shares to confer identical rights to distributions and liquidation proceeds.

The agreement required the maintenance of capital accounts under § 704(b), a section typically associated with partnership taxation that tracks each shareholder’s equity stake based on contributions, allocations of income, and distributions. Critically, the agreement tied each shareholder’s liquidating distribution rights directly to their capital account balance, resulting in disproportionate economic rights among shareholders. For example, a shareholder with a higher capital account balance would receive a larger share of liquidation proceeds than a shareholder with a lower balance, even if both held identical stock.

Prior to Date 3, the corporation made disproportionate cash distributions to certain shareholders without equalizing these amounts among all owners. These distributions were not tied to any formal compensation arrangement or binding agreement to restore parity.

To address the issue, the corporation amended its operating agreement on Date 3, effective immediately. The revised agreement removed all references to capital accounts, eliminated the linkage between liquidation rights and capital balances, and explicitly stated that all shares conferred identical distribution and liquidation rights. Additionally, the corporation filed amended employment tax returns in Month to reclassify the prior disproportionate distributions as compensation to the affected shareholders.

IRS Grants Relief Under § 1362(f) for Inadvertent Termination

The IRS analyzed the termination of X’s S corporation election under § 1362(f), which permits relief when an S election terminates inadvertently if the corporation corrects the issue and agrees to required adjustments. Section 1362(f) requires four elements for relief: (1) the termination must result from circumstances beyond the corporation’s control; (2) the corporation must take corrective steps within a reasonable period after discovery; (3) the corporation and affected shareholders must agree to adjustments as required by the Secretary; and (4) the IRS must determine that granting relief is equitable.

The IRS concluded the termination was inadvertent because the corporation’s operating agreement flaws—specifically provisions linking liquidation rights to capital accounts—created a second class of stock under § 1361(b)(1)(D) and Treas. Reg. § 1.1361-1(l). The corporation’s prompt corrective actions—amending the operating agreement to remove capital account references, equalize distribution rights, and reclassify disproportionate distributions as compensation—demonstrated reasonable diligence in addressing the violation. The IRS emphasized that the relief scope is limited to the inadvertent termination issue; it expressed no opinion on other S corporation eligibility requirements, such as shareholder count or entity type.

This ruling underscores that § 1362(f) relief hinges on timely, good-faith corrective action and that operating agreements must strictly adhere to the one-class-of-stock rule to avoid unintended terminations.

Implications for S Corporations with Similar Operating Agreements

The IRS’s granting of relief under § 1362(f) in this case underscores critical risks for S corporations with operating agreements containing capital account provisions or language that could inadvertently create multiple classes of stock. Operating agreements that permit disproportionate allocations of income, loss, or liquidation proceeds—even if unintentional—violate the one-class-of-stock requirement under § 1361(b)(1)(D), which mandates identical economic rights for all shareholders. The IRS’s emphasis on timely corrective action in this ruling highlights the need for S corporations to conduct annual reviews of their governing documents to ensure compliance with S corporation requirements.

Tax practitioners should advise clients to scrutinize operating agreements for provisions that could trigger a second class of stock, such as unequal profit/loss allocations, preferential redemption rights, or debt instruments that function as equity. The IRS’s willingness to grant relief under § 1362(f) is contingent on prompt correction and good-faith efforts, but it does not extend to other eligibility requirements, such as shareholder count or entity type. This ruling serves as a reminder that operating agreements must be drafted with precision to avoid unintended terminations, and that reliance on boilerplate language without legal review poses significant risk.

While § 1362(f) provides a pathway for relief in cases of inadvertent termination, taxpayers should not assume similar outcomes without consulting their own counsel. Private Letter Rulings are non-precedential under § 6110(k)(3) and cannot be cited as precedent, meaning other taxpayers facing comparable issues must seek their own rulings or rely on the IRS’s streamlined procedures under Rev. Proc. 2022-19. This ruling does not address broader S corporation eligibility, such as compliance with the 100-shareholder limit or the prohibition on ineligible shareholders, reinforcing the need for comprehensive compliance beyond the inadvertent termination issue.