Conditional relief granted for invalid S election and trust shareholder

Plain-English summary

An S corporation’s original election omitted the signature of a shareholder’s community-property spouse. Later, a trust intended to be a qualified subchapter S trust held shares but its governing agreement allowed more than one income beneficiary, making it an ineligible shareholder. The IRS found the resulting termination inadvertent and treated the corporation as continuing its S status while the trust held the shares. Relief depended on the corporation timely obtaining separate automatic relief for the missing spousal consent under Revenue Procedure 2004-35.

Ruling snapshot

• Question: Can the corporation receive relief for an invalid S election and a later termination caused by an ineligible trust shareholder?
• Outcome: approved conditionally, with automatic-relief filing required for the original invalid election
• Key authorities: IRC §§ 1361, 1362(f); Rev. Proc. 2004-35

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201933004                                              Third Party Communication: None
Release Date: 8/16/2019                                        Date of Communication: Not Applicable
Index Number: 1361.01-02, 1362.01-01,
              1362.04-00                                       Person To Contact:
                                                               -----------------------, ID No. ----------------
                                                               Telephone Number:
----------------------------------------                       ----------------------
------------------------                                       Refer Reply To:
-------------------------------                                CC:PSI
---------------------------                                    PLR-132106-18
---------------------------                                    Date:
                                                               May 21, 2019


Legend

X=                 ----------------------------------------
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A=                 -----------------------
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B=                 ----------------------
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C=                 ------------------
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D=                 -----------------------------------------
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E=                 -------------------------------------------------------------
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F=                 -----------------------
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G=                 ----------------------------
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Date 1 =          --------------------

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

Date 3 =          --------------------
PLR-132106-18                                 2


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

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

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

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

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

This letter responds to a letter dated October 24, 2018, submitted on behalf of X, by X's
authorized representative, requesting relief from an inadvertent invalid election and
termination under § 1362(f) of the Internal Revenue Code (Code).

                                          FACTS

According to the information submitted, X was formed on Date 1 as a corporation under
the laws of State. Effective Date 2, X elected to be treated as an S corporation. X's
shareholders consented to the S corporation election, including A, but the signature of
A’s community property spouse, B, was inadvertently omitted from the election. Both A
and B represented that at all times since X’s S corporation election was filed on Date 2,
all items of income, gain, loss, deduction, or credit were reported consistently with such
election on all affected federal income tax returns.

In its submission, X represented that it meets the criteria for and requested automatic
relief under Rev. Proc. 2004-35 for failing to include B’s signature with its S corporation
election.

Further, as part of the estate planning for C, D was formed as a grantor trust. E was
formed pursuant to the terms of D’s trust agreement and became a shareholder of X on
Date 3. X represents that because D was a defective grantor trust all items of income,
gain, loss, deduction, or credit of X were reported on C’s individual tax returns. C died
on Date 4.

Subsequent to Date 4, X requested relief under Rev. Proc. 2003-43 for a late filed
qualified subchapter S trust (QSST) election for E. The IRS granted the relief on Date 5.
Unbeknownst to X, E’s governing trust agreement provided for more than one income
beneficiary, thereby causing E’s QSST election to be invalid. X represents that because
E’s QSST election was invalid E was an ineligible shareholder of X and caused an
inadvertent termination of X’s S corporation election on Date 4.
PLR-132106-18                                 3

X represents that F, as sole income beneficiary of E, reported E’s allocable share of
income, gain, loss, deduction, or credit from Date 4 until Date 6. On Date 6, E
transferred its X shares to G, a permissible S corporation shareholder.

X represents that the ineffectiveness of its S election and 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. Additionally, X represents that X and its
shareholders have filed their federal income tax returns consistent with having a valid S
corporation election in effect for X. X and its shareholders agreed to make any
adjustments consistent with the treatment of X as an S corporation as may be required
by the Secretary with respect to the period specified by § 1362(f).

                                   LAW AND ANALYSIS

Section 1361(a)(1) of the Code 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) defines a “small business corporation” as 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)(2), 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 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(d)(1) provides that in the case of a qualified subchapter S trust with
respect to which a beneficiary makes an election under § 1361(d)(2), the trust is treated
as a trust described in § 1361(c)(2)(A)(i), and 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)(3) defines the term “qualified subchapter S trust” as a trust all of the
income (within 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.
In addition, the terms of the trust must 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 in the trust 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
PLR-132106-18                                  4

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 such beneficiary.

Section 1362(a)(1) provides that, except provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

Section 1361(d)(2) provides that a beneficiary of a qualified subchapter S trust (or his
legal representative) may elect to have § 1361(d) apply. An election under § 1362(d)(2)
shall be made separately with respect to each corporation the stock of which is held by
the trust.

Section 1362(d)(2)(A) provides that an election under § 1362(a) is 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. Section
1362(d)(2)(B) provides that any termination under § 1362(d)(2)(A) is effective on and
after the date of cessation.

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation (A)
was not effective for the tax 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, or (B) was terminated under paragraph (2) or (3) of § 1362(d); (2)
the Secretary determines that the circumstances resulting in such ineffectiveness or
termination were inadvertent, (3) no later than a reasonable period of time after
discovery of the event resulting in the ineffectiveness or termination, 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 or termination, the
corporation shall be treated as an S corporation during the period specified by the
Secretary

                                       CONCLUSION

Based solely on the facts submitted and representations made, we conclude X’s S
corporation election was invalid because the original S corporation election failed to
include the signature of a community property spouse who was a shareholder solely
pursuant to state community property law.

Even if X’s S election was valid, we conclude that X's S corporation election terminated
on Date 4 due to the failure of E being a permissible shareholder under § 1361(d)(3)
and that the termination was inadvertent within the meaning of § 1362(f). Accordingly,
PLR-132106-18                                  5

X will be treated as continuing to be an S corporation from Date 4 and to Date 6,
provided that its S corporation election was otherwise valid and was not otherwise
terminated under § 1362(d).

Such relief is conditioned on X filing a request for automatic relief for X’s invalid S
election effective from Date 2 under Rev. Proc. 2004-35, with the appropriate service
center within 120 days from the date of this letter. A copy of this letter should be
attached to the request for automatic relief. If X or its shareholders fail to seek
automatic relief under Rev. Proc. 2004-35, this ruling is null and void.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, no opinion is expressed or implied concerning the eligibility of X
to be an S corporation.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to X's authorized representative.

                                       Sincerely,

                                       __________________________
                                       Adrienne M. Mikolashek
                                       Branch Chief, Branch 3
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosures (2)

Copy of letter
Copy of letter for § 6110 purposes


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