S corporation receives relief after stock was issued to an ineligible shareholder

Plain-English summary

An S corporation issued shares to another corporation, an ineligible S-corporation shareholder, causing its election to terminate. After discovering the problem, an eligible individual acquired the shares. The IRS found the termination inadvertent under IRC § 1362(f) and allowed the company to be treated as continuously maintaining its S election. The former corporate shareholder still had to report its share of S-corporation income, basis adjustments, and distributions for the period it owned the stock.

Ruling snapshot

• Question: Was the S election's termination caused by the ineligible corporate shareholder inadvertent?
• Outcome: Approved, continuous S-corporation treatment granted
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201634013 Third Party Communication: None
Release Date: 8/19/2016 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
--------------------------------- ----------------------, ID No. -------------
--------------------------- Telephone Number:
----------------------- ---------------------
----------------------------- Refer Reply To:
CC:PSI:B01
PLR-137830-15
Date:
May 16, 2016

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

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

A = -------------------

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

State B = ----------------------

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

Date 2 = -------------------
-------------------------------------------------------------------------------------------------------------------
Date 3 = ---

Dear -----------------

This letter responds to a letter dated November 11, 2015, submitted on behalf of X,
requesting relief under § 1362(f) of the Internal Revenue Code.

Facts

The information submitted states that X was formed under the laws of State on Date 1
and elected to be treated as an S corporation effective Date 1. On Date 2, X issued
shares of its stock to Y, a State B corporation. Therefore, X’s election terminated on
Date 2. Upon discovering the existence of the ineligible shareholder, A, an eligible
shareholder of X, acquired Y's shares of X stock effective Date 3.
PLR-137830-15 2

X represents that the issuance of X stock to Y, an ineligible shareholder, was not
motivated by tax avoidance or retroactive tax planning. Additionally, X represents that X
and its shareholders have filed their federal income tax returns consistent with having a
valid S corporation election in effect for X. 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 Secretary with respect to the period specified by § 1362(f).

Law

Section 1361(a)(1) defines an “S corporation” as a small business corporation for which
an election under § 1362(a) is in effect for the taxable year.

Section 1361(b)(1)(B) provides that a “small business corporation” means a domestic
corporation that is not an ineligible corporation and that 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 1362(d)(2) 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 a
corporation is an S corporation) such corporation ceases to be a small business
corporation. A termination of an S corporation election under § 1362(d)(2) is effective
on and after the date of cessation.

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation was
terminated under § 1362(d)(2) or (3), (2) the Secretary determines that the
circumstances resulting in such termination were inadvertent, (3) no later than a
reasonable period of time after discovery of the event resulting in the ineffectiveness,
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 such
ineffectiveness, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

Conclusion

Based solely on the information submitted and the representations made, we conclude
that X’s S corporation election terminated on Date 2 when shares of X were transferred
to Y, an ineligible shareholder. We further conclude that the termination was
inadvertent within the meaning of § 1362(f).
PLR-137830-15 3

Accordingly, pursuant to the provisions of § 1362(f), X will be treated as continuing to be
an S corporation from Date 2 and thereafter, provided X's S corporation election was
valid and was not otherwise terminated under § 1362(d). During the period of Date 2 to
Date 3, Y will be treated as a shareholder of X; according, Y must include in its income
any distributions received from X during the period of ownership, and must include in
income its pro rata share of the separately and nonseparately stated items of X as
provided in § 1366, make any adjustments to stock basis as provided in § 1367, and
take into account any distributions made by X as provided in § 1368.

Except for the specific ruling above, we express no opinion concerning the federal tax
consequences of the facts described above under any other provision of the Code.
Specifically, no opinion is expressed concerning whether X was otherwise eligible to be
treated as an S corporation.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

Pursuant to a power of attorney on file with this office, a copy of this letter is being sent
to X’s authorized representative.

                                    Sincerely,


                                    Laura C. Fields
                                    Laura C. Fields
                                    Senior Technician Reviewer, Branch 1
                                    Office of the Associate Chief Counsel
                                    (Passthroughs & Special Industries)

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

cc: