Ineligible trust ownership treated as inadvertent S termination

Plain-English summary

An eligible trust transferred S corporation shares to a complex trust without realizing that the receiving trust was not an eligible S corporation shareholder. The company and its shareholders continued to report consistently with S corporation treatment, and the ineligible trust later returned all the shares to the original trust. The company represented that the termination was not motivated by tax avoidance or retroactive tax planning and agreed to make any required adjustments. The IRS ruled that the termination was inadvertent and treated the company as an S corporation throughout the affected period and afterward. During the termination period, the original trust is treated as having held the shares directly. The IRS did not decide whether the company was otherwise eligible for S corporation status.

Ruling snapshot

• Question: Can the corporation retain S status after shares were temporarily held by an ineligible complex trust?
• Outcome: approved
• Key authorities: IRC §§ 1361(b)(1), 1362(d)(2), 1362(f), 1366, 1367, 1368

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201740001                                            Third Party Communication: None
Release Date: 10/6/2017                                      Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                             Person To Contact:
---------------------------------------------------------    -----------------------------, ID No. -------------
----------------------------                                 -----------------
---------------------------                                  Telephone Number:
-------------------------------                              ----------------------
                                                             Refer Reply To:
                                                             CC:PSI:01
                                                             PLR-101266-17
                                                             Date:
                                                             June 19, 2017


Legend

X                 = ----------------------------------------------------------------------------------------------
                    ---------------------------------------------------------
State             = -----------------
Date 1            = ------------------
Date 2            = ----------------------
Date 3            = -------------------
Date 4            = --------------------
Date 5            = ---------------------------
Trust 1           = ----------------------------------------------------------------
Trust 2           = -------------------------------------


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

       This responds to a letter dated December 30, 2016, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling relating to X’s status as an S corporation under §§ 1361 and 1362 of the
Internal Revenue Code.

                                                     FACTS

        The information submitted states that X was incorporated under the laws of State
on Date 1 and elected to be an S corporation effective Date 2. On Date 3, Trust 1, an
eligible shareholder, transferred shares of X to Trust 2. The trustee of Trust 1 was not
aware that Trust 2 was not an eligible S corporation shareholder and the transfer would
terminate X's S corporation election.
PLR-101266-17                                2

      On or about Date 4, X’s accountant learned that Trust 2 was a complex trust and
was not eligible to be an S corporation shareholder and that the transfer terminated X’s
S corporation election effective Date 3.

      On Date 5, Trust 2 distributed all of its shares of X stock to Trust 1.

       X represents that the termination of its S corporation election was inadvertent
and not motivated by tax avoidance or retroactive tax planning. Further, since Date 3, X
and X's shareholders have continually treated X as an S corporation. As such, all items
of income, gain, loss, and deduction recognized by X since Date 3 have been allocated
among the shareholders of X. X and its shareholders have agreed to make such
adjustments as the Service may require with respect to all periods since Date 3.

                                 LAW AND ANALYSIS

      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.
PLR-101266-17                                 3

                                      CONCLUSION

       Based solely on the information submitted and the representations made, we
conclude that X's S corporation election was terminated on Date 3 when shares of X
were transferred to Trust 2, an ineligible shareholder. We conclude, however, that this
termination was inadvertent within the meaning of § 1362(f). Accordingly, pursuant to
the provisions of § 1362(f), X will be treated as an S corporation effective Date 3 and
thereafter.

        During the termination period, Trust 1 will be treated as if it held the shares in X
directly. Accordingly, in determining their respective income tax liabilities during the
termination period and thereafter, X's shareholders must include their pro rata share of
the separately and nonseparately computed items of X as provided in § 1366, make any
adjustments to basis as provided in § 1367, and take into account any distributions
made by X as provided in § 1368.

       Except as specifically set forth above, no opinion is expressed concerning the
federal tax consequences of the facts described above under any other provision of the
Code. Specifically, no opinion is expressed on whether X was or is otherwise eligible to
be treated as an S corporation.

        This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of
the Code 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 forwarded to X's
authorized representatives.


                                       Sincerely,


                                       Laura C. Fields
                                       Laura C. Fields
                                       Senior Technician Reviewer, Branch 1
                                       (Passthroughs & Special Industries)

Enclosures (2)
 Copy of Letter
 Copy for 8110 purposes