Corporation received relief for two inadvertent S election terminations

Plain-English summary

An S corporation's election terminated when a trust shareholder transferred shares to a partnership, which was not an eligible S corporation shareholder. A second trust also would have caused another termination after it continued holding shares for more than two years after its deemed owner's death without making an electing small business trust election. The IRS ruled that both terminations were inadvertent under IRC § 1362(f). It allowed the corporation to remain an S corporation if the partnership distributed all its shares to eligible shareholders and the second trust filed an ESBT election, each within 120 days of the letter. The relief also depended on the corporation's election being valid and not otherwise terminated.

Ruling snapshot

• Question: Could two S corporation election terminations caused by ineligible shareholders be treated as inadvertent?
• Outcome: Approved, subject to corrective distributions and an ESBT election within 120 days
• Key authorities: IRC §§ 1361 and 1362

Full text (IRS public release)

Internal Revenue Service                                         Department of the Treasury
                                                                 Washington, DC 20224

Number: 201623002                                                Third Party Communication: None
Release Date: 6/3/2016                                           Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                                 Person To Contact:
--------------------------------                                 ------------------------, ID No. ------------------
-------------------------------------------                      ----------------------------------------------------
----------------------                                           Telephone Number:
-----------------------------                                    --------------------
                                                                 Refer Reply To:
                                                                 CC:PSI:B3
                                                                 PLR-127780-15
                                                                 Date: February 4, 2016




LEGEND

X                 =        -----------------------------------
                           -----------------------

Y                 =        ------------------------------------------------
                  -----------------------

Trust 1           =        -------------------------

Trust 2           =        ----------------------------------------------------------
                  -----------------------

A                 =         ---------------------------
---------------------------
State             =         -------------

Date 1            =        -----------------------

Date 2            =        ---------------------

Date 3            =        -------

Date 4            =        ------------------------

Date 5            =        ------------------------
PLR-127780-15                                2


Dear -------------:

       This letter responds to a letter dated August 10, 2015, and subsequent
correspondence, submitted on behalf of X, requesting a ruling under § 1362(f) of the
Internal Revenue Code (Code).

FACTS

       The information submitted states that X was incorporated in State on Date 1 and
elected to be treated as an S corporation effective Date 2. In Date 3, Trust 1, a
shareholder of X, contributed shares of X to Y, a partnership, an ineligible S corporation
shareholder under § 1361(b)(1)(B). As a result, X’s S corporation election terminated
Date 3.

In addition, shares of stock in X are held by Trust 2. Trust 2 was a grantor trust
described in § 1361(c)(2)(A)(i) of which A was the deemed owner. A died on Date 4.
Relative to A's shares of X stock, Trust 2 qualified under § 1361(c)(2)(A)(ii) as an
eligible shareholder for two years from A's date of death. However, Trust 2 continued to
hold the X stock after the two-year period. According to X, Trust 2 qualifies as an
electing small business trust ("ESBT"), but its trustee made no ESBT election. As a
result, X’s S corporation election would have terminated Date 5 had the election not
already terminated Date 3.

       X represents that the termination of X’s S corporation election was not motivated
by tax avoidance or retroactive tax planning. X and its shareholders have agreed to
make any adjustments consistent with the treatment of X as an S corporation as may be
required by the Commissioner with respect to the period specified by § 1362(f).

LAW

        Section 1361(a)(1) provides that the term "S corporation" means, with respect to
any taxable year, a small business corporation for which an election under § 1362(a) is
in effect for such year.

       Section 1361(b)(1) provides, in part, that the term "small business corporation"
means a domestic corporation which is not an ineligible corporation and which does not
have as a shareholder a person (other than an estate, a trust described in § 1361(c)(2),
or an organization described in § 1361(c)(6)) who is not an individual.

       Section 1361(c)(2)(A)(i) provides that, for purposes of § 1361(b)(1)(B), the
following trust may be an S corporation shareholder: a trust all of which is treated
(under subpart E of part 1 of subchapter J of chapter 1 of the Code) as owned by an
individual who is a citizen or resident of the United States.
PLR-127780-15                                 3


       Section 1361(c)(2)(A)(ii) provides that for purposes of § 1361(b)(1)(B), the
following trust may be an S corporation shareholder: a trust which was described in
§ 1361(c)(2)(A)(i) immediately before the death of the deemed owner and which
continues in existence after such death may be a shareholder, but only for the 2-year
period beginning on the day of the deemed owner's death.

     Section 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT
may be an S corporation shareholder.

        Section 1361(e)(1)(A) provides that for purposes of § 1361, except as provided in
§ 1361(e)(1)(B), the term "electing small business trust" means any trust if (i) such trust
does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III)
an organization described in § 170(c)(2), (3), (4), or (5), or (IV) an organization
described in § 170(c)(1) which holds a contingent interest in such trust and is not a
potential current beneficiary, (ii) no interest in such trust was acquired by purchase, and
(iii) an election under § 1361(e) applies to such trust. Section 1361(e)(3) provides that
an election under § 1361(e) shall be made by the trustee. Any such election shall apply
to the taxable year of the trust for which made and all subsequent taxable years of such
trust unless revoked with the consent of the Secretary.

       Section 1362(d)(2)(A) provides that an election under § 1362(a) shall be
terminated whenever (at any time on or after the first day of the first taxable year for
which the corporation is an S corporation) such corporation ceases to be a small
business corporation.

        Section 1362(f) provides, in part, that if (1) an election under § 1362(a) by any
corporation (A) was not effective for the taxable year for which made (determined
without regard to § 1362(b)(2)) by reason of a failure to meet the requirements of
§ 1361(b) or to obtain shareholder consents or (B) was terminated under § 1362(d)(2)
or (3), (2) the Secretary determines that the circumstances resulting in the
ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of
time after discovery of the circumstances resulting in the ineffectiveness or termination,
steps were taken (A) so that the corporation is a small business corporation or (B) to
acquire the required shareholder consents, and (4) the corporation and each person
who was a shareholder of the corporation at any time during the period specified
pursuant to § 1362(f), agrees to make such adjustments (consistent with the treatment
of the corporation as an S corporation) as may be required by the Secretary with
respect to such period, then, notwithstanding the circumstances resulting in the
ineffectiveness or termination, the corporation will be treated as an S corporation during
the period specified by the Secretary.
PLR-127780-15                                 4

CONCLUSION

        Based solely on the facts submitted and representations made, we conclude that
X's S corporation election terminated on Date 3 because X had an ineligible
shareholder. However, we conclude that the termination on Date 3, was inadvertent
within the meaning of § 1362(f). Accordingly, under § 1362(f), X will be treated as
continuing to be an S corporation on and after Date 3, provided that X's S corporation
election was valid and not otherwise terminated under § 1362(d). As a condition to this
ruling, Y must distribute all of its X stock to eligible shareholders within 120 days of the
date of this letter.

        We further conclude that X's S corporation election would have terminated on
Date 5 (after the two-year period beginning on H's death) due to the trustee's failure to
make an ESBT election for Trust 2 had the election not already terminated Date 3. We
also conclude that such termination would have constituted an inadvertent termination
within the meaning of § 1362(f). Accordingly, X will be treated as continuing to be an S
corporation from Date 5, and thereafter, provided that its S corporation election was
otherwise valid and was not otherwise terminated under § 1362(d). Moreover, relative to
A's shares of X stock, Trust 2 will be treated as an ESBT from Date 5, and thereafter,
provided the trustee of Trust 2 files an ESBT election for Trust 2 with the appropriate
service center, effective Date 5, within 120 days of the date of this letter. A copy of this
letter should be attached to the election.

        Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the facts of this case under any other provisions of the
Code. Specifically, we express or imply no opinion as to whether X is otherwise eligible
to be treated as an S corporation or whether Trust 2 is otherwise eligible to be treated
as an ESBT within the meaning of 1361(e)(1)(A).

       The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

       This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
of the Code provides that it may not be used or cited as precedent.
PLR-127780-15                               5


      In accordance with a power of attorney on file with this office, we are sending a
copy of this letter to your authorized representatives.


                                     Sincerely,



                                     Richard T. Probst
                                     Senior Technician Reviewer, Branch 3
                                     Office of Associate Chief Counsel
                                     (Passthroughs & Special Industries)



Enclosures (2)
      Copy of this letter
      Copy for § 6110 purposes