John R. Bullis: S corporation did not create second class of stock

IRS Private Letter Ruling PLR 201633017 held an S corporation that erroneously paid disproportionate distributions, but later corrected it, did not create a second class of stock.

In year 1, the corporation made a mistake in figuring the ownership percentage information it used to calculate the shareholder distributions. Near the end of year 2, it hired an accounting firm. Then the corporation learned of the mistake in distributions in year 1. The corporation then made correcting distributions.

It all was caused by an error in determining the percentage ownership of each individual shareholder.

IRS looked at all the facts including the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements. IRS found that because the S corporation’s governing provisions provided for identical distribution and liquidation rights and because it did not have a principal purpose to circumvent the one class of stock requirement, it did not create a second class of stock.

If a second class of stock was created, then it could not file an S corporation income tax return, form 1120S. Instead it would file form 1120, a regular corporation income tax return and the corporation would have to pay tax on the earnings.

The profit (or loss) of an S corporation is reported on a Schedule K-1 form and the individual shareholders report their share of the profit (or loss) on their individual income tax returns. That usually results in less tax being paid and avoids the second taxable event when the S corporation pays distributions to the shareholders. It would be expensive if a second class of stock had been created and the form 1120S could not be filed for year 1 and later.

This is an example of looking at all the facts and making clear there was no intent to not make the S corporation distributions correctly, so it all worked out OK. IRS seems to have acted properly in ruling that a second class of stock was not created.

By taking action to discover the mistake in calculating the percentage ownerships timely and taking action to get it all corrected, a lot of trouble and expense in the future was avoided. It is not fun to discover a mistake or work to get it corrected. But it is like a splinter under your fingernail. It is going to hurt a little to pull it out, but that is the best thing to do in the long run.

It is a shame our tax laws are so complicated. It is easy to expect the corporation involved spent a lot of time and money just to make the correct distributions and get the proper returns filed.

Did you hear? “People who squawk about their income taxes may be divided into two classes. They are: men and women,” by Anonymous.

John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.