Missed ESBT filings were treated as an inadvertent S election termination

Plain-English summary

Two individual shareholders transferred S corporation shares to three nongrantor trusts. The trusts qualified to elect as electing small business trusts, but their trustees failed to file the elections on time, which terminated the corporation's S election. The corporation represented that the error was inadvertent, was not tax-motivated, and that all parties reported consistently with S corporation and ESBT treatment. The IRS preserved the corporation's S status if it was otherwise valid and required each trust to file an ESBT election effective on the transfer date within 120 days. The ruling did not decide whether the corporation or trusts otherwise qualified for those tax classifications.

Ruling snapshot

• Question: Could the corporation keep S status after three trusts failed to make timely ESBT elections?
• Outcome: Approved, conditioned on corrective ESBT elections within 120 days.
• Key authorities: IRC §§ 1361(c)(2), 1361(e), 1362(d), 1362(f); Treas. Reg. §§ 1.1361-1(m), 1.1362-4

Full text (IRS public release)

Internal Revenue Service                                    Department of the Treasury
                                                            Washington, DC 20224

Number: 201745009                                           Third Party Communication: None
Release Date: 11/9/2017                                     Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                            Person To Contact:
--------------------------------------------                -----------------------------, ID No. -------------
-----------------------------------------------------       -----------------
-------------------------------                             Telephone Number:
---------------------------                                 --------------------
                                                            Refer Reply To:
                                                            CC:PSI:01
                                                            PLR-121374-17
                                                            Date:
                                                            August 03, 2017

Legend

X              = ------------------------------------------------------------------------------------------------
                 ----------------------------------
State          = ----------
Date 1         = ----------------------------
Date 2         = -----------------------
A              = ------------------------------------------------------------------------------------------------
                 -----------------------------------
B              = ------------------------------------------------------------------------------------------------
                 -----------------------------------
Trust 1        = ------------------------------------------------------------------------------------------------
                 ----------------------------------
Trust 2        = ------------------------------------------------------------------------------------------------
                 ----------------------------------
Trust 3        = ------------------------------------------------------------------------------------------------
                 ----------------------------------


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

      This responds to a letter dated July 6, 2017, and subsequent correspondence
submitted on behalf of X by X’s authorized representative, requesting inadvertent
termination relief under § 1362(f) of the Internal Revenue Code.

                                                        FACTS

        The information submitted states that X was incorporated under the laws of State
on Date 1. X filed a timely election under § 1362(a) to be treated as an S corporation
effective Date 1. On Date 2, A and B, individual shareholders of X, established Trust 1,
Trust 2, and Trust 3, nongrantor trusts whose beneficiaries were all U.S. citizens. On
Date 2, A and B transferred shares of X stock to each of Trust 1, Trust 2, and Trust 3.
PLR-121374-17                                 2


       X represents that Trust 1, Trust 2, and Trust 3 each qualified to elect to be
treated as electing small business trusts (ESBTs) under § 1361(e), however, the
trustees for each of the trusts failed to make timely ESBT elections within the meaning
of § 1361(e)(1)(A)(v) thereby causing X’s S corporation election to terminate on Date 2.

       X represents that the circumstances resulting in the termination of X’s S
corporation election were inadvertent and not motivated by tax avoidance. X further
represents that X filed returns consistent with X’s status as an S corporation. X also
represents that, on Date 2, Trust 1, Trust 2, and Trust 3 each qualified to be an ESBT
and continue to qualify as an ESBT. X further represents that Trust 1, Trust 2, and
Trust 3 each filed returns consistent with rules applicable to ESBTs. X and its
shareholders agree to make such adjustments (consistent with the treatment of X as an
S corporation) as may be required by the Secretary.

                                  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)(B) provides that, for purposes of subchapter S, the term
“small business corporation” means a domestic corporation which is not an ineligible
corporation and which 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 1361(c)(2)(A)(v) provides that for the purposes of § 1362(b)(1)(B), an
ESBT may be a shareholder.

         Section 1361(e)(1)(A) provides that for purposes of § 1361, except as provided in
§ 1361(e)(1)(B), the term “electing small business trust” 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)(3) provides that
an election under § 1361(e) shall 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 part, that
the trustee of the trust must make the ESBT election by signing and filing, with the
PLR-121374-17                                3

service center where the S corporation files its income tax return, a statement that
meets the requirements of § 1.1361-1(m)(2)(ii).

      Section 1362(d)(2) 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 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 circumstances resulting in such
termination, steps were taken so that the corporation for which the termination occurred
is a small business corporation, and (4) the corporation for which the termination
occurred, and each person who was a shareholder in such corporation at any time
during the period specified pursuant to 1362(f), 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 an S
corporation during the period specified by the Secretary.

       Section 1.1362-4(b) provides, in relevant part, that for purposes of § 1.1362-4(a),
the determination of whether a termination was inadvertent is made by the
Commissioner. The corporation has the burden of establishing that under the relevant
facts and circumstances the Commissioner should determine that the termination was
inadvertent. The fact that the terminating event was not reasonably within the control of
the corporation and was not part of a plan to terminate the election, or the fact that the
terminating event or circumstance took place without the knowledge of the corporation,
notwithstanding its due diligence to safeguard itself against such an event or
circumstance, tends to establish that the termination was inadvertent.

       Section 1.1362-4(d) provides, in part, that the Commissioner may require any
adjustments that are appropriate. In general, the adjustments should be consistent with
the treatment of the corporation as an S corporation during the period specified by the
Commissioner.

       Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election terminated beginning on Date 2 because the trustees of Trust
1, Trust 2, and Trust 3 failed to timely file the required ESBT elections under
§ 1361(e)(1)(A)(v). We further conclude that the termination was inadvertent within the
meaning of § 1362(f) and X will continue to be treated as an S corporation for the period
from Date 2 provided that X’s S corporation election was valid and was not otherwise
terminated under § 1362(d).
PLR-121374-17                                 4

       This ruling is conditioned upon the trustees of Trust 1, Trust 2, and Trust 3 filing a
ESBT elections effective upon Date 2. The elections must be filed with the appropriate
service center within 120 days of the date of this ruling. A copy of this letter should be
attached to the ESBT elections.

        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 X is
otherwise eligible to be treated as an S corporation or whether Trust 1, Trust 2, or Trust
3 is eligible to be treated as an ESBT. 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. Pursuant to a power of attorney on file, 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
                                       (Passthroughs & Special Industries)

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


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