Missed QSST elections caused an inadvertent S corporation termination

Plain-English summary

An S corporation's stock was held through two trusts that became divided into separate shares after shareholder deaths. The shares could no longer rely on the temporary rules for post-death trusts, and their beneficiaries failed to make timely qualified subchapter S trust elections. Some shares under the second trust also did not initially satisfy the QSST document requirements, although the beneficiaries and trustees later entered a binding state-law settlement intended to correct them. The corporation and affected taxpayers consistently reported as though S status and QSST treatment had continued, and they represented that the failures were inadvertent rather than tax-motivated. The IRS treated the S election as continuing despite both sets of ineligible trust shareholders. Relief is conditioned on filing the required QSST elections for all affected shares within 120 days and continuing to report the corporation's items, basis adjustments, and distributions consistently with S corporation treatment.

Ruling snapshot

• Question: Will the corporation retain S status despite trust shares becoming ineligible shareholders when QSST elections were missed?
• Outcome: Approved as an inadvertent termination, subject to QSST elections within 120 days
• Key authorities: IRC §§ 1361(c), 1361(d), 1362(d), 1362(f); Treas. Reg. § 1.1361-1(h), (j)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201903007                                              [Third Party Communication:
Release Date: 1/18/2019                                        Date of Communication: Month DD, YYYY]
Index Number: 1362.04-00
                                                               Person To Contact:
----------------------------                                   ---------------------, ID No. -----------
------------------------------------------                     Telephone Number:
-------------------                                            ----------------------
---------------------------------------                        Refer Reply To:
                                                               CC:PSI:B01
                                                               PLR-110166-18
                                                               Date:
                                                               September 28, 2018




Legend

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

A                 =         -------------------------
------------------------------------------------------

B                 =         -----------------------------
------------------------------------------------------

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

Trust 1           =         ------------------------------------------
----------------------------------------------------

Share 1A          =        ------------------------------------------------------------------------------------------

Share 1B          =        ------------------------------------------------------------------------------------------

Share 1C          =         -----------------------------------------------------------------------------------------
                           -----------

Share 1D          =        ------------------------------------------------------------------------------------------

Share 1E          =        ------------------------------------------------------------------------------------------

Share 1F          =        ------------------------------------------------------------------------------------------

Trust 2           =         ---------------------------------------------------
----------------------------------------------------

Share 2A          =         -----------------------------------------------------------------------------------------
                           -----------

Share 2B          =         -----------------------------------------------------------------------------------------
                           ----------------------

Share 2C          =         -----------------------------------------------------------------------------------------
                           -----------

Share 2D          =         -----------------------------------------------------------------------------------------
                           ---------------------

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

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

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

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

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

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

Date 7            =        -----------------------

Date 8            =        ---------------------------


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

      This responds to a letter dated March 9, 2018, and subsequent correspondence,
submitted on behalf of X, requesting a ruling 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 and elected to be treated as an S corporation effective Date 2. As of Date 2,
A’s shares of X were held through Trust 1, a grantor trust that was treated (under
subpart E of part 1 of subchapter J of chapter 1) as entirely owned by A.

       On Date 3, A died and Trust 1 ceased to be a grantor trust. Nevertheless,
Trust 1 continued to qualify as a permissible S corporation shareholder under
§ 1361(c)(2)(A)(ii) for the 2-year period beginning Date 3 . Trust 1’s trust agreement
provided that upon the death of A, the X stock held by Trust 1 is to be held by six
shares, Share 1A, Share 1B, Share 1C, Share 1D, Share 1E, and Share 1F (collectively
Trust 1 Shares). Each Trust 1 share is treated as a separate share under § 663(c).

       X represents that each of the Trust 1 shares would have qualified as a qualified
subchapter S trust (QSST) under § 1361(d)(1) on Date 4 except for the fact that the sole
beneficiary of each share failed to make an election under § 1361(d)(2) to treat the
share as a QSST. Accordingly, the Trust 1 shares became ineligible shareholders of X
and X’s S corporation election terminated effective Date 4.

        On Date 5, B, a shareholder of X died. Pursuant to B’s last will and testament,
B’s estate transferred B’s X stock to Trust 2 on Date 6. Trust 2 qualified as a
permissible S corporation shareholder under § 1361(c)(2)(A)(iii) for the 2-year period
beginning on Date 6, the day on which the X stock was transferred to it. Effective Date
6, trustees held Trust 2 in five shares. Four shares, Share 2A, Share 2B, Share 2C,
and Share 2D (Trust 2 Shares), held X stock and were administered as QSSTs,
effective Date 7. Although the Trust 2 Shares were administered as QSSTs no election
under § 1362(d)(2) was made to treat the Trust 2 shares as QSSTs effective Date 7 and
the governing document of Trust 2 did not satisfy the requirements to qualify the Trust 2
shares as QSSTs.

       On Date 7, the Trust 2 Shares became ineligible shareholders of X. On Date 8,
the beneficiaries the Trust 2 Shares and the trustees of Trust 2 entered into a binding
non-judicial settlement agreement under State law effective as of Date 6 to qualify the
Trust 2 shares as QSSTs.

        X represents that all income has been reported on all affected returns consistent
with the treatment of X as an S corporation for Date 2 and thereafter. X further
represents that the beneficiaries of the Trust 1 shares and the Trust 2 Shares have filed
their federal income tax returns consistent with the Trust 1 shares and Trust 2 shares
being treated as QSSTs. X represents that the circumstances resulting in the
termination of X’s S corporation election were inadvertent and were not motivated by tax
avoidance or retroactive tax planning.

    X and its shareholders have agreed to make any adjustments that the
Commissioner may require, consistent with the treatment of X as an S corporation.

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 § 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)(i) provides that, for the purposes of § 1362(b)(1)(B), a trust
all of which is treated (under title 26, subtitle A, chapter 1, subchapter J, part I, subpart
E of the United States Code) as owned by an individual who is a citizen or resident of
the United States may be a shareholder of an S corporation.

        Section 1361(c)(2)(A)(ii) and § 1.1361-1(h)(1)(ii) of the Income Tax Regulations
provide that, for purposes of § 1361(b)(1)(B), a trust that is described in
§ 1361(c)(2)(A)(i) immediately before the death of the deemed owner and that continues
in existence after such death is a permitted shareholder, but only for the two-year period
beginning on the day of the deemed shareholder’s death.

       Section 1361(c)(2)(A)(iii) and § 1.1361-1(h)(1)(iv)(A) of the Income Tax
Regulations provide that, for purposes of § 1361(b)(1)(B), a trust with respect to stock
transferred to it pursuant to the terms of a will may be a shareholder, but only for the
two-year period beginning on the day on which such stock is transferred to it.

       Section 1.1361-1(h)(3)(i)(B) of the Income Tax Regulations provides that, if stock
is held by a trust described in § 1.1361-1(h)(1)(ii), the estate of the deemed owner is
generally treated as the shareholder as of the day of the deemed owner’s death.

        Section 1.1361-1(h)(3)(i)(D) of the Income Tax Regulations provides that, if stock
is transferred to a testamentary trust described in § 1.1361-1(h)(1)(iv), the estate of the
testator is treated as the shareholder until the earlier of the transfer of that stock by the
trust or the expiration of the two-year period beginning on the day that the stock is
transferred to the trust.

        Section 1361(d)(1) provides that, in the case of a qualified subchapter S trust
with respect to which a beneficiary makes an election under § 1361(c)(2), (A) such trust
will be treated as a trust described in § 1361(c)(2)(A)(i), and (B) for purposes of § 678(a)
the beneficiary of such trust shall be treated as the owner of that portion of the trust
which consists of stock in an S corporation with respect to which the election under
§ 1361(d)(2) is made.

       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) provides that the term “qualified subchapter S trust” means a
trust (A) the terms of which require that (i) during the life of the current income
beneficiary, there shall be only 1 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 income beneficiary in the trust
shall terminate on the earlier of such beneficiary’s death or the termination of the trust,
and (iv) upon termination of the trust during the life of the current income beneficiary,
the trust shall distribute all of its assets to such beneficiary, and (B) all of the income
(within the meaning of § 643(b)) of which is distributed (or required to be distributed)
currently to 1 individual who is a citizen or resident of the United States.

        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)(iii) 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 1.1361-1(j)(6)(iii)(C) provides that if a trust ceases to be a qualified
subpart E trust, satisfies the requirements of a QSST, and intends to become a QSST,
the QSST election must be filed within the 16-day-and-2-month period beginning on the
date on which the trust ceases to be a qualified subpart E trust. If the estate of the
deemed owner of the trust is treated as the shareholder under § 1.1361-1(h)(3)(i), the
QSST election may be filed at any time, but no later than the end of the 16-day-and-2-
month period beginning on the date on which the estate of the deemed owner ceases to
be treated as a shareholder.

       Section 1.1361-1(j)(7)(i) provides that the income beneficiary who makes the
QSST election and is treated (for purposes of § 678(a)) as the owner of that portion of
the trust that consists of S corporation stock is treated as the shareholder for purposes
of §§ 1361(b)(1), 1366, 1367, and 1368.

      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(f) provides 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) or
to obtain shareholder consents; (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, or to acquire the required shareholder consents; and (4) the corporation for
which the election was made, 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 ineffectiveness, such corporation
shall be treated as an S corporation during the period specified by the Secretary.

       Rev. Rul. 93-79, 1993-2 C.B. 269, provides that a reformation of a trust to meet
the requirements of a QSST is recognized prospectively.

Conclusion

       Based solely on the information submitted and the representations made, we
conclude that X’s S corporation election was terminated on Date 4, when the Trust 1
shares became ineligible shareholders. We conclude that the termination of X’s S
corporation election was an inadvertent termination within the meaning of § 1362(f).
Moreover, had X’s S corporation election not already terminated on Date 4, it would
have terminated on Date 7, when the Trust 2 shares became ineligible shareholders.
Similarly, this termination would have also been inadvertent. Accordingly, pursuant to
the provisions of § 1362(f), X will be treated as an S corporation from Date 4 and
thereafter, provided that X’s S corporation election was otherwise valid and not
otherwise terminated under § 1362(d).

        This ruling is contingent on QSST elections being made for the Trust 1 shares
effective Date 4 and elections being made for the Trust 2 shares effective Date 8 within

120 days of the date of this letter. A copy of this letter should be attached to the QSST
elections.

        The shareholders of X must include their pro-rata share of the separately stated
and non-separately computed items of X as provided in § 1366, make 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 treat themselves as described above,
this ruling is null and void.

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the transactions 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.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

       In accordance with a power of attorney on file with this office, a copy of this letter
is being sent to X’s authorized representative.


                                       Sincerely,


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



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