Late QSST elections and unequal distributions receive S relief

Plain-English summary

After a shareholder died, S corporation shares passed from a formerly grantor trust to two trusts intended to qualify as qualified Subchapter S trusts. The beneficiary did not timely make QSST elections, and the trustees also failed to distribute all trust income currently, causing or potentially causing the corporation's S election to terminate. The corporation had separately made disproportionate shareholder distributions that could have been viewed as creating a second class of stock, although its governing documents gave every share identical distribution and liquidation rights. The IRS treated the trust failures and any termination from the unequal distributions as inadvertent. Relief required retroactive QSST elections for both trusts within 120 days, distribution of all unpaid trust income within that period, corrective shareholder distributions, consistent S corporation reporting, and any required tax adjustments.

Ruling snapshot

• Question: Could the corporation preserve S status despite late QSST elections, undistributed trust income, and potentially disproportionate shareholder distributions?
• Outcome: approved, subject to corrective trust elections, income distributions, and consistent shareholder treatment
• Key authorities: IRC §§ 1361(d), 1362(f), 1366, 1367, and 1368; Treas. Reg. § 1.1361-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201710001 [Third Party Communication:
Release Date: 3/10/2017 Date of Communication: Month DD, YYYY]
Index Number: 1362.04-00
Person To Contact:
------------------------------------------- -----------------------------, ID No. -------------
------------------------ -----------------
-------------------------------- Telephone Number:
---------------------------------------- ----------------------
Refer Reply To:
CC:PSI:01
PLR-115103-16
Date:
November 04, 2016

Legend

Company = --------------------------------------------------------------------------------------------
----------------------------------
State = --------------
Date 1 = ---------------------
Date 2 = ---------------------
Date 3 = ------------------
Date 4 = ---------------------
Date 5 = ----------------------
Date 6 = --------------------
A = ------------------------
B = --------------------------------------------------------------------------------------------
----------------------------------
Trust 1 = --------------------------
Trust 2 = --------------------------------------------------------------------------------------------
------------------------
Trust 3 = --------------------------------------------------------------------------------------------
-----------------------------------
Period = ---------------------------------------------------

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

   This letter responds to a letter received by our office, dated May 6, 2016,

submitted on behalf of Company by its authorized representatives, requesting rulings
related to its S elections under § 1362(f) of the Internal Revenue Code.

                                                FACTS

PLR-115103-16 2

  Company represents that it was incorporated on Date 1 under the laws of State

and elected to be treated as an S corporation effective Date 2. On Date 2, A and B
owned all of the outstanding shares of Company. On Date 3, A and B transferred
shares of Company stock to Trust 1; a revocable trust treated as a wholly-owned
grantor trust under §§ 671 and 676.

   On Date 4, A died and Trust 1 ceased to be a grantor trust with respect to A’s

interests, but continued to qualify as an eligible S corporation shareholder under
§ 1361(c)(2)(A)(ii) for the two year period beginning on the date of A’s death. Following
A’s death, Trust 1 continued to be a grantor trust with respect to B’s interest

   Effective Date 5, A’s shares of Company stock were transferred to Trust 2 and

Trust 3. Company represents that Trust 2 and Trust 3 intended to be qualified
subchapter S trusts (QSSTs) described in § 1361(d)(3)(A) as of Date 5 and thereafter.
However, B, the income beneficiary, failed to make QSST elections within the meaning
of § 1361(d)(2), thereby causing Company’s S corporation election to terminate on Date
5.

    Company represents that the trustee of Trust 2 and Trust 3 failed to distribute

currently all of its income to B. On Date 6, Trust 3 distributed all of its undistributed
income to B. Company represents the trustee of Trust 2 plans to take remedial steps to
distribute all undistributed income to B. Had Company's S corporation election not
terminated on Date 5, the failure of the trust to distribute all of its income currently to the
income beneficiaries would have terminated Company's S corporation election

    Further, Company learned that the distributions it made for Period were not

consistent with its governing instruments and could be construed as creating a second
class of stock, and thus, could potentially have terminated its S corporation election
effective beginning Period.

    Company represents that each share of Company stock has identical rights to

liquidation proceeds and distributions under its governing documents and no provisions
exist in its articles of incorporation, by-laws, or other agreement that varies these rights.
Neither Company nor its shareholders knew that disproportionate distributions could
potentially terminate Company’s S corporation election.

    Company represents that it has taken remedial steps to make corrective

distributions to its shareholders to eliminate the cumulative amount of the
disproportionate distributions made from Company to its shareholders. Company
further represents that the disproportionate distributions were inadvertent and Company
always intended to be an S corporation.

  Company and its shareholders represent that at all times they intended Company

be an S corporation. Company represents that Company and its shareholders have
PLR-115103-16 3

filed their federal income tax returns consistent with having a valid S corporation
election in effect for Company. Company and its shareholders have agreed to make
such adjustments (consistent with the treatment of Company as an S corporation) as
may be required by the Secretary.

                                        LAW

    Section 1361(a)(1) provides that the term “S corporation” means, with respect to

any tax year, a small business corporation for which an election under § 1362(a) is in
effect for that year.

    Section 1361(b)(1) provides that the term “small business corporation” means a

domestic corporation which is not an ineligible corporation and which 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)(3), 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 1362(b)(5) provides that if (A) an election under § 1362(a) is made for

any taxable year (determined without regard to § 1362(b)(3)), after the date prescribed
by § 1362(b) for making such election for such taxable year or no such election is made
for any taxable year, and (B) the Secretary determines that there was reasonable cause
for the failure to timely make the election, the Secretary may treat such an election as
timely made for the taxable year (and § 1362(b)(3) shall not apply).

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

under § 1362(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.
Under § 1361(d)(2)(A), a beneficiary of a QSST may elect to have § 1361(d) apply.
Under § 1361(d)(2)(D), this election will be effective up to 15 days and two 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
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.
PLR-115103-16 4

    Section 1.1361-1(j)(3) provides that for purposes of § 1361(c) and § 1361(d), a

substantially separate and independent share of a trust, within the meaning of § 663(c)
and the regulations thereunder is treated as a separate trust. For a separate share
which holds S corporation stock to qualify as a QSST, the terms of the trust applicable
to that separate share must meet the QSST requirements stated in § 1.1361-1(j)(1)(i)
and (ii).

   Section 1.1361-1(j)(6)(ii) provides that the current income beneficiary of the trust

must make the election under § 1361(d)(2) by signing and filing with the service center
where the corporation files its income tax return the applicable form or a statement
including the information listed in § 1.1361-1(j)(6)(ii).

   Section 1362(a) provides, in part, that a small business corporation may elect to

be an S corporation. Section 1362(d)(2)(A) provides that an election under § 1362(a)
shall be terminated whenever at any time on or after the 1st day of the 1st 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 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), (2)
the Secretary determines that the circumstances resulting in such ineffectiveness were
inadvertent, (3) no later than a reasonable period of time after discovery of the
circumstances resulting in such ineffectiveness, steps were taken so that the
corporation for which the election was made is a small business corporation, and (4) the
corporation for which the election was made, and each person who was a shareholder
in the corporation at any time during the period specified pursuant to § 1362(f), agrees
to make 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.

   Section 1.1361-1(l)(1) of the Income Tax Regulations provides that a corporation

that has more than one class of stock does not qualify as a small business corporation.
Except as provided in § 1.1361-1(l)(4)(relating to instruments, obligations, or
arrangements treated as a second class of stock), a corporation is treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds. Differences in voting rights
among shares of stock of a corporation are disregarded in determining whether a
corporation has more than one class of stock. Thus, if all shares of stock of an S
corporation have identical rights to distribution and liquidation proceeds, the corporation
may have voting and nonvoting common stock, a class of stock that may vote only on
certain issues, irrevocable proxy agreements, or groups of shares that differ with
respect to rights to elect members of the board of directors.
PLR-115103-16 5

    Section 1.1361-1(l)(2)(i) provides that the determination of whether all

outstanding shares of stock confer identical rights to distribution and liquidation
proceeds is made based on the corporate charter, articles of incorporation, bylaws,
applicable state law, and binding agreements relating to distribution and liquidation
proceeds. Although a corporation is not treated as having more than one class of stock
so long as the governing provisions provide for identical distribution and liquidation
rights, any distributions (including actual, constructive, or deemed distributions) that
differ in timing or amount are to be given appropriate tax effect in accordance with the
facts and circumstances.

   Section 1.1361-1(l)(3) provides that, except as provided in §§ 1.1361(b)(3), (4),

and (5) (relating to restricted stock, deferred compensation plans, and straight debt), in
determining whether all outstanding shares of stock confer identical rights to distribution
and liquidation proceeds, all outstanding shares of stock of a corporation are taken into
account.

                                  CONCLUSION

     Based solely on the facts submitted and representations made, we conclude that

Company's S corporation election terminated beginning on Date 5, when the stock in
Company was transferred to Trust 2 and Trust 3 because B failed to timely file the
required QSST elections under § 1361(d)(2). Had Company’s S corporation election
not already terminated, we conclude that the failure of Trust 2 and Trust 3 to distribute
all of its income as required by § 1361(d)(3) would have caused Company’s S
corporation election to terminate. We further conclude that these terminating events
were inadvertent within the meaning of § 1362(f).

    This relief is contingent upon the income beneficiaries of Trust 2 and Trust 3 filing

a QSST election for Trust 2 and Trust 3 effective Date 5 within 120 days from the date
of this letter. A copy of this letter should be attached to the election. In addition, Trust 2
must, within 120 days of the date of this letter, distribute to B all income required to be
distributed under § 1361(d)(3) not previously distributed.

    Had Company’s S corporation election not already terminated, we further

conclude that, if distributions made by Company to its shareholders that failed to comply
with its operating documents caused Company’s S corporation election to terminate, the
termination was inadvertent within the meaning of § 1362(f). Therefore, Company will
be treated as an S corporation effective the beginning of Period and thereafter, provided
Company’s S corporation election is not otherwise terminated under § 1362(d). The
shareholders of Company must include their pro rata shares of the separately stated
and nonseparately computed items of income or loss of Company as provided in
§ 1366, make any adjustments to basis as provided in § 1367, and take into account
PLR-115103-16 6

any distributions made by Company as provided in § 1368. The failure to take the action
described above shall cause this ruling to be null and void.

    Except as expressly provided herein, we express or imply no opinion concerning

the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter. Specifically, we express or imply no opinion regarding whether Company is
otherwise eligible to be an S corporation or whether Trust 2 or Trust 3 meet the
requirements of a QSST.

    This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the

Code provides that it may not be used or cited as precedent. 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.

  In accordance with the power of attorney on file with this office, we are sending a

copy of this letter to Company's authorized representatives.

                                   Sincerely,


                                   Faith P. Colson
                                   Faith P. Colson
                                   Senior Counsel, Branch 1
                                   (Passthroughs & Special Industries)

Enclosures (2)
Copy of Letter
Copy for § 6110 purposes