LLC shareholder problem is cured with retroactive trust elections

Plain-English summary

An S corporation sold shares to an LLC taxed as a partnership, which was an ineligible shareholder even though its partners were two trusts. After the corporation discovered the termination, the LLC distributed its shares to the trusts according to their ownership interests. One trust elected QSST status and the other elected ESBT status from the corrective distribution date. The IRS found the original termination inadvertent and allowed the corporation's S election to continue. Relief required both trusts to file elections retroactive to the LLC purchase date within 120 days and required the corporation and shareholders to report consistently with the trusts treated as direct shareholders from that date.

Ruling snapshot

• Question: Could the corporation preserve S status after stock was sold to an ineligible LLC and later distributed to a QSST and an ESBT?
• Outcome: approved, conditioned on retroactive QSST and ESBT elections
• Key authorities: IRC §§ 1361(d), 1361(e), 1362(d), and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201709015 Third Party Communication: None
Release Date: 3/3/2017 Date of Communication: Not Applicable
Index Number: 1362.01-00, 1362.01-02,
1362.02-00, 1362.02-02, Person To Contact:
1362.04-00, 1362.00-00 ----------------------------,
ID No. ------------------
--------------------------------------- Telephone Number:
----------------------------------------- ----------------------
------------------------- Refer Reply To:
----------------------------- CC:PSI:B01
PLR-123317-16
Date:
November 01, 2016

LEGEND

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

State = -----------

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

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

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

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

LLC = ---------------------------------------------------------------------------------------------------

Trust1 = -----------------------------------------
PLR-123317-16 2

Trust2 = ----------------------------------------

a = --------

b = ----------

c = ----------

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

  This responds to a letter dated July 21, 2016, and subsequent correspondence,

submitted on behalf of X by X's authorized representative, requesting relief under
§ 1362(f) of the Internal Revenue Code (the Code).

FACTS

    According to the information submitted, X was incorporated under the laws of

State on Date 1. X elected to be treated as an S corporation effective Date 1. On Date
2, a shares of stock in X were sold to LLC, a partnership for federal tax purposes. The
partners of LLC were Trust 1 and Trust 2, both trusts. LLC, as a partnership, was an
ineligible shareholder of an S corporation. On Date 3, X's accountant learned that the
transfer of stock to LLC terminated X's S election. On Date 4, LLC distributed all of its a
shares of X stock to Trust 1 and Trust 2 in accordance with their relative interests in
LLC, b shares to Trust 1 and c shares to Trust 2. Effective on Date 4, Trust 1 made an
election to be a qualified subchapter S trust (“QSST”) within the meaning of
§ 1361(d)(3) and Trust 2 made an election to be an Electing Small Business Trust
(“ESBT”) within the meaning of § 1361(e)(1).

    X represents that Trust 1 has at all times since Date 2 satisfied the requirements

of a QSST, except that until Date 4 Trust 1 did not own the stock of X and the
beneficiary of Trust 1 did not make a QSST election. X represents that Trust 2 has at
all times since Date 2 satisfied the requirements of an ESBT, except that until Date 4
Trust 2 did not own the stock of X and the trustees of Trust did not make an ESBT
election.
PLR-123317-16 3

    X represents that, from Date 2 onward, it filed its tax returns as if it were an S

corporation. X represents that the amount of tax paid during this period was the same
as if Trust1 held b shares in X stock directly as a QSST and Trust2 held c shares in X
stock directly as an ESBT.

   X represents that it did not intend for its S corporation election to terminate and

that the events that resulted in the termination were not motivated by tax avoidance or
retroactive tax planning. Further, X and its shareholders agree to make any
adjustments required by the Secretary consistent with the treatment of X as an S
corporation.

LAW AND ANALYSIS

    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) defines a “small business corporation” as a domestic

corporation that is not an ineligible corporation and that does not (A) have more than
100 shareholders, (B) 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, (C) have a nonresident alien as a shareholder, and (D) have more than one
class of stock.

    Section 1361(c)(2)(A)(i) provides that a trust, all of which is treated (under

subpart E of part I of subchapter J of chapter 1) as owned by an individual who is a
citizen or resident of the United States, may be an S corporation shareholder.

   Section 1361(d)(1) provides that a QSST whose beneficiary makes an election

under § 1361(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the
QSST's beneficiary will be treated as the owner (for purposes of § 678(a)) of that portion
of the QSST's S corporation stock to which the election under § 1362(d)(2) applies.

   Section 1361(d)(2)(A) provides that a beneficiary of a QSST (or his legal

representative) may elect to have § 1361(d) apply. Section 1361(d)(2)(D) provides that
an election under § 1362(d)(2) shall be effective up to 15 days and 2 months before the
date of the election.

    Section 1361(d)(3) defines a QSST as a trust (A) the terms of which require that

(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust; (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary; (iii) the income interest of the
current beneficiary in the trust shall terminate on the earlier of the beneficiary's death or
the termination of the trust; and (iv) upon the termination of the trust during the life of the
PLR-123317-16 4

current income beneficiary, the trust shall distribute all of its assets to that beneficiary;
and (B) all of the income (with the meaning of § 643(b)) of which is distributed (or
required to be distributed) currently to one individual who is a citizen or resident of the
United States.

   Section 1.1361-1(j)(6)(iii) of the Income Tax Regulations provides that if S

corporation stock is transferred to a trust, the QSST election must be made within the
16-day-and-2-month period beginning on the day that the stock is transferred to the
trust.

 Section 1361(c)(2)(A)(v) provides that, for purposes of § 1362(b)(1)(B), an ESBT

may be an S corporation shareholder.

     Section 1361(e)(1)(A) provides that an ESBT 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)(1)(B) provides that an ESBT does not include (i) any qualified

subchapter S trust (as defined in § 1361(d)(3)) if an election under § 1361(d)(2) applies
to any corporation the stock of which is held by such trust, (ii) any trust exempt from tax
under subtitle A, and (iii) any charitable remainder annuity trust or charitable remainder
unitrust (as defined in § 664(d)).

   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 1.1361-1(m)(2)(i) of the Income Tax Regulations provides, in relevant

part, that the trustee of an ESBT must make the ESBT election by signing and filing,
with the service center where the S corporation files its income tax return, a statement
that meets the requirements of § 1.1361-1(m)(2)(ii). Generally, only one ESBT election
is made for the trust, regardless of the number of S corporations whose stock is held by
the ESBT. However, if the ESBT holds stock in multiple S corporations that file in
different service centers, the ESBT election must be filed with all the relevant service
centers where the corporations file their income tax returns. This requirement applies
only at the time of the initial ESBT election; if the ESBT later acquires stock in an S
corporation which files in a different service center, a new ESBT election is not required.

 Section 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the

ESBT election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a
PLR-123317-16 5

QSST election (generally within the 16-day-and-2-month period beginning on the day
that the stock is transferred to the trust).

  Section 1362(d)(2)(A) provides that an election under § 1362(a) shall be

terminated whenever the corporation ceases to be a small business corporation.

   Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a)

by any corporation was terminated under paragraph (2) or (3) of § 1362(d), (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
circumstances resulting in termination, steps were taken so that the corporation is once
more a small business corporation, 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 any adjustments (consistent with the treatment of the
corporation as an S corporation) as may be required by the Secretary with respect to
the period, then, notwithstanding the circumstances resulting in the termination, the
corporation will be treated as continuing to be 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 election terminated on Date 2 when the X stock was sold to LLC.
We further conclude that the termination 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 2, provided that X's S corporation election was valid and
not otherwise terminated under § 1362(d). However, this ruling is contingent upon the
beneficiary of Trust 1 filing a QSST election with an effective date of Date 2, and the
trustees of Trust 2 filing an ESBT election with an effective date of Date 2. The QSST
and ESBT elections must be filed with the appropriate service center within 120 days
from the date of this letter. A copy of this letter should be attached to the QSST and
ESBT elections.

   If the QSST and ESBT elections are made as instructed herein, Trust 1 shall be

treated as owning b shares of the stock of X from Date 2 and Trust 2 shall be treated as
owning c shares of the stock of X from Date 2. Accordingly, the shareholders of X,
including Trust 1 and Trust 2, must include in income their pro rata share of the
separately stated and nonseparately computed items of X as provided in § 1366, make
an adjustments to basis as provided in § 1367, and take into account any distributions
made by X as provided in § 1368. If X or its shareholders fail to make these elections or
treat X as described above, this letter ruling will be null and void.
PLR-123317-16 6

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, no opinion is expressed concerning whether X is
otherwise eligible to be treated as an S corporation, whether Trust 1 is eligible to be a
QSST, or whether Trust 2 is eligible to be an ESBT.

  This ruling is directed only to the taxpayer who requested it. According to

§ 6110(k)(3), this ruling may not be used or cited as precedent.

    Pursuant to the power of attorney on file with this office, we are sending a copy of

this letter to X’s authorized representative.

                                      Sincerely,



                                      Faith P. Colson
                                      Faith P. Colson
                                      Senior Counsel, Branch 1
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)


   Enclosures (2)

Copy of this letter
Copy of this letter for § 6110 purposes

cc: