Passive-income termination of S status was inadvertent

Plain-English summary

An S corporation had accumulated C corporation earnings and profits and, for three consecutive years, received passive investment income exceeding 25 percent of gross receipts. Those facts automatically terminated its S election at the start of the following year. The corporation said its advisers had failed to explain the passive-income rules, it continued filing as an S corporation, and the termination was not part of tax avoidance or retroactive planning. The IRS ruled that the termination was inadvertent and allowed continuous S status, conditioned on the corporation making a specified payment to the IRS within 120 days.

Ruling snapshot

• Question: Can an S corporation retain continuous S status after three years of excess passive investment income caused an automatic termination?
• Outcome: approved as an inadvertent termination, conditioned on a specified payment within 120 days
• Key authorities: IRC §§ 1362(d)(3) and (f) and 1375; Treas. Reg. §§ 1.1362-4 and 1.1368-1(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202005004 Third Party Communication: None
Release Date: 1/31/2020 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.02-00,
1362.02-03, 1362.04-00, Person To Contact:
1375.00-00 -----------------------, ID No. -------------------
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------------------------------------- Telephone Number:
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------------------------------- Refer Reply To:
------------------------------------ CC:PSI:B01
PLR-105474-19
Date:
September 10, 2019

LEGEND:

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

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

Date 1 = -------

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

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

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

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

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

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

a = ----------------

b = ------------------

PLR-105474-19 2

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

This letter responds to a letter dated March 13, 2019, and subsequent correspondence,
submitted on behalf of X by X’s authorized representatives, requesting inadvertent
termination relief under § 1362(f) of the Internal Revenue Code.

Facts

The information submitted states that X is a corporation organized under the laws of
State on Date 1. On Date 3, X made an election to be an S corporation effective Date 2.

At the close of three consecutive taxable years ending Date 6, X had subchapter C
accumulated earnings and profits of $a. In addition, for each taxable year ending
Date 4, Date 5, and Date 6, X had passive investment income (within the meaning of
§ 1362(d)(3)) in excess of 25 percent of its gross receipts. As a result, X’s S corporation
election terminated on Date 7.

X represents that its tax advisors inadvertently failed to inform X of the passive
investment rules. In addition, X represents that the termination of X’s S corporation
election was inadvertent and not motivated by tax avoidance or retroactive planning. X
further represents that since Date 2, X and its shareholders have filed all returns
consistent with X’s status as an S corporation. X and its shareholders have agreed 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 1362(d)(3)(A)(i) provides that an election under § 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 the termination under § 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 § 1362(d)(3)(A)(i).

Section 1362(d)(3)(C)(i) provides that the term “passive investment income” means,
except as otherwise provided in § 1362(d)(3), gross receipts derived from royalties,
rents, dividends, interest, and annuities.

PLR-105474-19 3

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation
(A) 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 or (B) was terminated under § 1362(d)(2) or (3), (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
circumstances resulting in such ineffectiveness or termination, steps were taken (A) so
that the corporation for which the election was made or the termination occurred is a
small business corporation or (B) to acquire the shareholder consents, and (4) the
corporation for which the election was made or 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 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, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

Section 1.1362-4(a) provides that a corporation is treated as continuing to be an S
corporation during the period specified by the Commissioner if (1) the corporation made
a valid election under § 1362(a) and the election terminated, (2) the Commissioner
determines that the termination was inadvertent, (3) within a reasonable period of time
after the discovery of the terminating event, steps were taken so that the corporation for
which the termination occurred is a small business corporation, and (4) the corporation
and shareholders agree to adjustments that the Commissioner may require for the
period.

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

Section 1375(a) provides that if for the taxable year an S corporation has
(1) accumulated earnings and profits at the close of such taxable year, and (2) gross
receipts more than 25 percent of which are passive investment income, then there is

PLR-105474-19 4

imposed a tax on the income of such corporation for such taxable year. Such tax shall
be computed by multiplying the excess net passive income by the highest rate of tax
specified in § 11(b).

Section 1375(b)(1)(A) provides that for purposes of § 1375, except as provided in
§ 1375(b)(1)(B), the term “excess net passive income” means an amount which bears
the same ratio to the net passive income for the taxable year as (i) the amount by which
the passive investment income for the taxable year exceeds 25 percent of the gross
receipts for the taxable year bears to (ii) the passive investment income for the taxable
year.

Section 1375(b)(1)(B) provides that the amount of the excess net passive income for
any taxable year shall not exceed the amount of the corporation’s taxable income for
such taxable year as determined under § 63(a): (i) without regard to the deductions
allowed by part VIII of subchapter B (other than the deduction allowed by § 248, relating
to organizational expenditures), and (ii) without regard to the deduction under § 172.

Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or part of
its subchapter C earnings and profits through a deemed dividend. If an S corporation
makes the election provided in § 1.1368-1(f)(3), the S corporation will be considered to
have made the election provided in § 1.1368-1(f)(2) (relating to the election to distribute
earnings and profits first).

Section 1.1368-1(f)(5)(iii) provides that a corporation makes an election for a taxable
year under § 1.1368-1(f) by attaching a statement to a timely filed (including extensions)
original or amended return required to be filed under § 6037 for that taxable year. In the
statement, the corporation must identify the election it is making under § 1.1368-1(f) and
must state that each shareholder consents to the election. The statement described in
§ 1.1368-1(f)(5)(iii) shall be verified by signing the return. A statement of election to
make a deemed dividend under § 1.1368-1(f) must include the amount of the deemed
dividend that is distributed to each shareholder.

Conclusion

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 7 under § 1362(d)(3)(A) because X had
subchapter C earnings and profits at the close of each of three consecutive taxable
years ending on Date 6, 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 on Date 7, and thereafter, provided that Company’s S corporation

PLR-105474-19 5

election was valid and has not otherwise terminated under § 1362(d), and provided that
the following condition is met: a payment of $b and a copy of this letter must be sent to
the following address: Internal Revenue Service, Kansas City Submission Processing
Campus, 333 W. Pershing Road, Kansas City, MO 64108, Stop 7777, Attn: Manual
Deposit.

X must send this payment no later than 120 days from the date of this letter. If this
condition is not met, then this ruling is null and void. Furthermore, if this condition is not
met, X must notify the Kansas City Submission Processing Campus that its S
corporation election has terminated.

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. In particular, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

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, we are sending a copy of
this letter to your authorized representative.

                                    Sincerely,


                                    Joy C. Spies
                                    Joy C. Spies
                                    Senior Technician Reviewer, Branch 1
                                    (Passthroughs & Special Industries)

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

cc: