Passive income termination receives S corporation relief

Plain-English summary

An S corporation had accumulated earnings and profits and received passive investment income exceeding 25 percent of gross receipts for three consecutive tax years. Those facts terminated its S election under section 1362(d)(3), even though the corporation had paid the excess net passive income tax for each year. The corporation represented that it did not know about the termination rule, intended to remain an S corporation, had reported consistently with that status, and was not engaged in retroactive tax planning. The IRS treated the termination as inadvertent and allowed S status to continue. Relief was conditioned on the corporation making a deemed dividend election and distributing all accumulated earnings and profits by the specified date.

Ruling snapshot

• Question: Could the corporation preserve S status after three years of excess passive investment income caused an automatic termination?
• Outcome: approved, conditioned on eliminating accumulated earnings and profits through a deemed dividend
• Key authorities: IRC §§ 1362(d)(3), 1362(f), and 1375(a); Treas. Reg. § 1.1368-1(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201710013 Third Party Communication: None
Release Date: 3/10/2017 Date of Communication: Not Applicable
Index Number: 1362.02-03, 1362.04-00
Person To Contact:
------------------------------- -----------------------
------------------- ID No. ------------------
------------------------------- Telephone Number:
----------------------------------- ----------------------
Refer Reply To:
CC:PSI:B01
PLR-121866-16
Date:
November 29, 2016

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

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

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

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

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

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

Date 5 = ----------------------

Date 6 = ---------------------------

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

   This responds to a letter dated June 13, 2016, submitted on behalf of X by its

authorized representatives, requesting relief under § 1362(f) of the Internal Revenue
Code (Code) with respect to the termination of X's S corporation election.

FACTS

  The information submitted indicates that X was incorporated in State. X filed

Form 2553, Election by a Small Business Corporation, effective Date 1.
PLR-121866-16 2

   At the time that X elected to be an S corporation, and for subsequent periods,

including the taxable years ending on Date 2, Date 3, and Date 4, X had accumulated
earnings and profits that were not distributed. X had passive investment income that
exceeded 25% of its gross receipts for the taxable years ending on Date 2, Date 3, and
Date 4. As a result, X's S corporation election terminated on Date 5 pursuant to
§ 1362(d)(3).

   X represents that it reported and paid the excess net passive income tax required

by § 1375(a) for each of the taxable years ending on Date 2, Date 3, and Date 4 but
was not aware of the termination provision in § 1362(d)(3)(A)(i). X represents that it
intended to maintain its S corporation status and that the termination of its S corporation
election was inadvertent. X represents that the termination of its S corporation election
was not part of a retroactive tax planning scheme or a plan to avoid federal income tax.
X represents that X and its shareholders consistently treated X as an S corporation for
all years since Date1.

 X represents that it will elect under § 1.1368-1(f)(3) to distribute all of its

accumulated earnings and profits through a deemed dividend no later than Date 6.

                             LAW AND ANALYSIS

  Section 1362(a) provides that, except as provided in § 1362(g), a small business

corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

   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 section
1362(a) is in effect for such year.

  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 the
corporation is an S corporation) such corporation ceases to be a small business
corporation. The termination is effective on and after the day of the termination.

    Section 1362(d)(3)(A)(i) provides that an election under section 1362(a) shall be

terminated whenever the corporation has accumulated earnings and profits at the close
of each of three consecutive taxable years, and has gross receipts for each of such
taxable years more than 25 percent of which are passive investment income. Section
1362(d)(3)(A)(ii) provides that any termination under section 1362(d)(3) shall be
effective on and after the first day of the first taxable year beginning after the third
consecutive taxable year referred to in section 1362(d)(3)(A)(i).

  Section 1362(f) provides that if (1) an election under section 1362(a) by any

corporation was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that
PLR-121866-16 3

the circumstances resulting in such termination were inadvertent, (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
termination, steps were taken so that the corporation is once more a small business
corporation, and (4) the corporation for which the termination occurred, and each
person who was a shareholder of such corporation at any time during the period
specified pursuant to this subsection, agrees to make such adjustments (consistent with
the treatment of such corporation as an S corporation) as may be required by the
Secretary with respect to such period, then, notwithstanding the circumstances resulting
in such termination, such corporation shall be treated as continuing to be an S
corporation during the period specified by the Secretary.

                                 CONCLUSION

   Based solely on the representations made and the information submitted, we

conclude that X's S corporation election terminated on Date 5 under § 1362(d)(3)
because X had accumulated earnings and profits at the close of each of three
consecutive taxable years beginning Date 2, and had gross receipts for each of those
taxable years more than 25 percent of which were passive investment income.

    We further conclude that the termination of X's S corporation election was an

inadvertent termination within the meaning of § 1362(f). Pursuant to the provisions of
§ 1362(f), X will be treated as continuing to be an S corporation beginning Date 5, and
thereafter, unless X's S corporation election is otherwise terminated under the
provisions of § 1362(d), provided the following conditions are met. X must distribute all
of its accumulated earnings and profits no later than Date 6. This distribution is to be
accomplished with a deemed distribution pursuant to an election made pursuant to
§ 1.1368-1(f) reflected on a federal income tax return to be filed by X for the taxable
year ended Date 6. X must attach a statement to such return that identifies the election,
states that each shareholder of X consents to the election, and identifies the amount of
the deemed dividend that is treated as being distributed to each shareholder. If these
conditions are not met, then this ruling is null and void. Furthermore, if these conditions
are not met, X must notify the Service Center with which X's S corporation election was
filed that the election has terminated.

   Except as specifically ruled above, we express or imply no opinion concerning

the federal income tax consequences of the facts described above under any other
provision of the Code. Specifically, we express or imply no opinion regarding whether X
is otherwise eligible to be an S corporation.

  A copy of this letter should be attached to X's federal tax return for the taxable

year ending Date 6. A copy is enclosed for that purpose.

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

provides that it may not be used or cited as precedent.
PLR-121866-16 4

   Pursuant to a power of attorney on file with this office, a copy of this letter will be

sent to X's authorized representatives.

                                    Sincerely,


                                    Joy C. Spies
                                    Joy C. Spies
                                    Senior Technician Reviewer
                                    Office of the Associate Chief Counsel
                                    (Passthroughs & Special Industries)

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