Missed ESBT elections receive S corporation and QSub relief

Plain-English summary

After an S corporation shareholder died, stock passed to several trusts that qualified as electing small business trusts, but the trustees failed to file timely ESBT elections. Those failures technically terminated the parent corporation's S election and one subsidiary's QSub election and made another subsidiary's QSub election ineffective. Because the corporation and shareholders consistently filed as though the statuses continued and the failures were inadvertent, the IRS granted relief. The parent remains an S corporation, and both subsidiaries receive QSub treatment, subject to ESBT elections and amended returns within 120 days and a redacted adjustment payment within 45 days. Failure to meet the conditions voids the ruling.

Ruling snapshot

• Question: May the parent and subsidiaries receive inadvertent-failure relief after trusts missed ESBT elections?
• Outcome: Approved, subject to late elections, amended returns, and an adjustment payment.
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202113001 Third Party Communication: None
Release Date: 4/2/2021 Date of Communication: Not Applicable
Index Numbers: 1361.05-00, 1362.00-00,
1362.04-00 Person To Contact:
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-------------------------- Telephone Number:
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---------------------- Refer Reply To:
----------------------------- CC:PSI:B03
PLR-112333-20
Date:
December 14, 2020

LEGEND

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

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Trust10 = ------------------------------------------------------------------------------------------

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Trust12 = -----------------------------------------------------------------------------
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Trust15 = ------------------------------------------------------------------------------------------

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

Date1 = --------------------------

Date2 = --------------------

Date3 = -------------------------

Date4 = ----------------

Date5 = --------------------------

Date6 = -------

Date7 = -------

Date8 = ----------------

Date9 = ----------------------------

N1 = ---

N2 = --------

N3 = --------

N4 = --------

N5 = ---------

N6 = -----------

N7 = ---------

Dear --------------:
PLR-112333-20 4

   This letter responds to a letter dated May 18, 2020, and subsequent

correspondence, submitted on behalf of X by X’s authorized representative, requesting
a ruling under § 1362(f) of the Internal Revenue Code (the Code).

                                     FACTS

   The information submitted states that X was formed under the laws of State on

Date1 and elected to be an S corporation effective Date1. Y and Z are wholly-owned
subsidiaries of X. X made elections under § 1361(b)(3)(B)(ii) to treat Y and Z as
Qualified Subchapter S Subsidiaries (“QSubs”) effective Date1 and Date2, respectively.
At the time of formation, A owned N1 shares of X. On Date3, A transferred N2 shares
of X to Trust1 and N3 shares of X to Trust2. On Date4, A died. X represents that prior
to A’s death, Trust1 and Trust2 were properly treated as grantor trusts under §§ 671-
678, and A was treated as owning the shares of X held by Trust1 and Trust2.

    On Date4, pursuant to the terms of the trust agreement for Trust1, Trust1 was

divided into four separate but equal shares for the benefit of certain grandchildren of A,
namely Trust3, Trust4, Trust5 and Trust6, and N4 shares of X were transferred to each
trust. Also on Date4, pursuant to the terms of the trust agreement for Trust2, Trust2
was divided into three separate but equal shares for the benefit of certain other
grandchildren of A, namely Trust7, Trust8, and Trust9, and N4 shares of X were
transferred to each trust. X represents that Trust3, Trust4, Trust5, Trust6, Trust7,
Trust8, and Trust9 (collectively, the “Grandchildren’s Trusts”) qualify as Electing Small
Business Trusts (ESBTs) under § 1361(e)(1)(A), but the trustees of the respective trusts
failed to file elections under § 1361(e)(3) effective Date4.

   Moreover, at the time of A’s death, the remaining N5 shares of X owned by A

were held in Trust10. X represents that prior to A’s death, Trust10 was properly treated
as a grantor trust under §§ 671-678, and A was treated as owning the shares of X held
by Trust10. Effective on Date4, the trustees of Trust11 purchased N5 shares of X from
Trust10. X represents that Trust11 qualified as an ESBT under § 1361(e)(1)(A), but the
trustee of Trust 11 failed to file an election under § 1361(e)(3) effective Date4.
Consequently, X’s S corporation election terminated on Date4. Because X’s S
corporation election terminated on Date4, its QSub election for Y also terminated on
Date4 and its QSub election for Z was ineffective.

   On Date5, pursuant to the terms of the trust agreement for Trust11, Trust11 was

divided into two separate but equal shares for the benefit for A’s surviving children,
namely Trust12 and Trust13 (the “Children’s Trusts”), and N6 shares of X were
transferred to each trust. X represents that the Children’s Trusts qualified as ESBTs
under § 1361(e)(1)(A) and filed ESBT elections under § 1361(e)(3). However, these
elections were filed late. Therefore, had X’s S corporation election not terminated on
Date4, it would have terminated on Date5. Nevertheless, X represents that Trust12 and
Trust13 filed consistently as ESBTs during taxable years Date6 through Date7.
PLR-112333-20 5

  On Date8, the shares of X held by Trust12 and Trust13 were transferred to

Trust14 and Trust15, respectively. X represents that Trust14 and Trust15 qualify as
ESBTs under § 1361(e)(1)(A) and filed late ESBT elections under § 1361(e)(3) effective
Date8 pursuant to Rev. Proc. 2013-30, 2013-36 I.R.B. 173.

    X represents that X and all of its shareholders have always filed tax returns

consistent with X being an S corporation. X further represents that the circumstances
resulting in the termination of X’s S corporation election and its QSub election for Y and
the ineffectiveness of its QSub election for Z were inadvertent and were not motivated
by tax avoidance or retroactive tax planning. X and its shareholders have agreed to
make adjustments consistent with the treatment of X as an S corporation, and the trusts
as ESBTs, 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) 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(b)(3)(B) provides that a QSub means any domestic corporation

which is not an ineligible corporation (as defined in § 1361(b)(2)), if (i) 100 percent of
the stock of such corporation is held by the S corporation, and (ii) the S corporation
elects to treat such corporation as a QSub.

   Section 1361(b)(3)(C) provides that if any corporation which was a QSub ceases

to meet the requirements of § 1361(b)(3)(B), such corporation shall be treated as a new
corporation acquiring all of its assets (and assuming all of its liabilities) immediately
before such cessation from the S corporation in exchange for its stock.

 Section 1361(c)(2)(A)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT

may be an S corporation shareholder.

     Section 1361(e)(1)(A) provides that an ESBT 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.
PLR-112333-20 6

   Section 1361(e)(1)(B) provides that an ESBT does not include (i) any qualified

subchapter S trust (as defined in § 1361(d)(3)) if an election under § 1361(d)(2) applies
to any corporation the stock of which is held by such trust, (ii) any trust exempt from tax
under subtitle A, and (iii) any charitable remainder annuity trust or charitable remainder
unitrust (as defined in § 664(d)).

   Section 1361(e)(3) provides that an election under § 1361(e) shall be 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 that the

trustee of an ESBT must make the ESBT election by signing and filing, with the 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 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the

ESBT election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a
QSST election (generally within the 16-day-and-2-month period beginning on the day
that the stock is transferred to the trust).

   Section 1362(d)(2) provides that (A) 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; and (B) any termination under § 1362(d)(2) shall be effective on
and after the date of cessation.

    Section 1362(f) provides that if (1) an election under § 1362(a) or

§ 1361(b)(3)(B)(ii) 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) or § 1361(b)(3)(C), (2) the Secretary determines that the
circumstances resulting in the ineffectiveness or termination were inadvertent, (3) no
later than a reasonable period of time after discovery of the circumstances resulting in
the ineffectiveness or termination, steps were taken (A) so that the corporation for which
the election was made or termination occurred is a small business corporation or a
QSub, as the case may be, or (B) to acquire the shareholder consents, and (4) the
corporation for which the election was made or termination occurred, 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 or a QSub, as the case may be) as may be
required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in the ineffectiveness or termination, the corporation will be
PLR-112333-20 7

treated as an S corporation or a QSub, as the case may be during the period specified
by the Secretary.

                                  CONCLUSION

    Based solely on the facts submitted and the representations made, we conclude

that X’s S corporation election and its QSub election for Y terminated on Date4 when
the trustees of the Grandchildren’s Trusts and Trust11 failed to make elections under
§ 1361(e)(3) to treat the Grandchildren’s Trusts and Trust11 as ESBTs effective Date4.
In addition, had X’s S corporation election and its QSub election for Y not terminated on
Date4, they would have terminated on Date5 when the trustees of the Children’s Trusts
failed to make elections timely under § 1361(e)(3) to treat the Children’s Trusts as
ESBTs effective Date5. Moreover, because X’s S corporation had terminated, its
election to treat Z as a QSub effective Date2 was ineffective. We further conclude that
the circumstances resulting in the termination of X’s S corporation election and its QSub
election for Y and its ineffective QSub election for Z were inadvertent within the
meaning of § 1362(f). Therefore, pursuant to the provisions of § 1362(f), X will be
treated as continuing to be an S corporation from Date4 and thereafter, provided that
X’s S corporation election was valid and was not otherwise terminated under § 1362(d)
for reasons not addressed in this letter. Furthermore, Y will be treated as continuing to
be a QSub from Date4 and thereafter, and Z will be treated as a QSub effective Date2
and thereafter, provided that the QSub elections for Y and Z were otherwise valid and
not otherwise terminated under § 1361(b)(3)(C) for reasons not addressed in this letter.

    This ruling is contingent on (1) the trustees of the Grandchildren’s Trusts filing

within 120 days from the date of this letter ESBT elections effective Date4 on behalf of
their respective trusts with the appropriate service center and (2) the Grandchildren’s
Trusts filing within 120 days from the date of this letter amended returns for taxable
years Date9 to properly reflect the treatment of the Grandchildren’s Trusts as ESBTs. A
copy of this letter should be attached to each ESBT election.

    Furthermore, as an adjustment under § 1362(f)(4), a payment of $N7 and a copy

of this letter must be sent within 45 days from the date of this letter to the following
address: Internal Revenue Service, Kansas City Submission Processing Campus, Attn:
Manual Deposit, 333 W. Pershing Road, Stop 7777, Kansas City, MO 64108.

    If the above conditions are not met, then this ruling is null and void. Furthermore,

if these conditions are not met, X must notify the service center with which it filed its S
corporation election that its election terminated on Date4.

   Except as specifically set forth above, we express or imply no opinion concerning

the federal tax consequences of the facts described above under any other provision of
the Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an
S corporation, and Y’s and Z’s eligibility to be QSubs. In addition, we express or imply
PLR-112333-20 8

no opinion as to whether the Grandchildren’s Trusts, the Children’s Trusts (including
Trust11), and Trust 14 and Trust 15 are eligible to elect to be treated as ESBTs.

   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 upon examination.

   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.

  In accordance with the power of attorney on file with this office, we are sending

copies of this letter to X’s authorized representatives.

                                  Sincerely,



                                  Mary Beth Carchia
                                  Senior Technician Reviewer, Branch 3
                                  Office of Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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

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