Deemed dividend cures S election termination from passive investment income

Plain-English summary

An S corporation had accumulated C corporation earnings and profits at the end of three consecutive tax years, and passive investment income exceeded 25 percent of gross receipts in each year. Those facts terminated its S election under Section 1362(d)(3). The corporation represented that the termination was inadvertent, was not motivated by tax avoidance or retroactive planning, and had been followed by consistent S corporation reporting. The IRS granted inadvertent-termination relief and treated the corporation as continuing its S status. Within 120 days, the corporation must amend its return to elect a deemed dividend distributing all accumulated earnings and profits, and its shareholders must amend their returns consistently.

Ruling snapshot

• Question: Can the corporation retain continuous S status after excess passive investment income caused its election to terminate?
• Outcome: Approved, conditioned on a deemed-dividend election and amended returns within 120 days
• Key authorities: IRC §§ 1362(d)(3) and (f), 1368, 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: 202138003                                              Third Party Communication: None
 Release Date: 9/24/2021                                        Date of Communication: Not Applicable
 Index Numbers: 1362.02-00, 1362.02-03,
               1362.04-00                                       Person To Contact:
                                                                -------------------, ID No. -----------------
 ------------------------------                                 Telephone Number:
 ------------------------------------------------------------   --------------------
 -------------------------                                      Refer Reply To:
 --------------------------------                               CC:PSI:B03
                                                                PLR-101009-21
                                                                Date:
                                                                June 23, 2021




LEGEND:

X                         = ------------------------------
                            ------------------------
State                     = ------
Date 1                    = ---------------------------
Date 2                    = ----------------------
Date 3                    = --------------------------
Date 4                    = --------------------------
Date 5                    = --------------------------
Date 6                    = ----------------------
Year                      = -------
Shareholders              = --------------------------------
                            --------------------------

                             -----------------------------
                             --------------------------

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



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

       This letter responds to a letter dated December 21, 2020, and subsequent
correspondence, submitted on behalf of X, requesting relief under § 1362(f) of the
Internal Revenue Code (Code).
PLR-101009-21                                2

                                           Facts

        According to the information submitted and representations made, X was
incorporated under the laws of State on Date 1 and elected to be an S corporation
effective Date 2. At the close of three consecutive taxable years ending Date 5, X had
subchapter C accumulated earnings and profits of $a. Moreover, for each taxable year
ending Date 3, Date 4, and Date 5, 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 6.

       X represents that the circumstances resulting in the termination of its S
corporation election on Date 6 were inadvertent, unintended, and not the result of tax
avoidance or retroactive tax planning. Also, X represents that it had no excess net
passive investment income for taxable years ending Date 3 and Date 4. Finally, X and
its Shareholders have consistently treated X as an S corporation since Date 2 and
agree to make any adjustments consistent with the treatment of X as an S corporation
as may be required by the Secretary including distributing all of its subchapter C
accumulated earnings and profits through a deemed dividend under § 1.1368-1(f)(3) of
the Income Tax Regulations.

                                     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 1362(d)(3)(A)(i) provides that an election under § 1362(a) terminates
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 any termination under § 1362(d)(3) is 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).

       Except as otherwise provided in § 1362(d)(3)(C), § 1362(d)(3)(C)(i) provides that
the term “passive investment income” means gross receipts derived from royalties,
rents, dividends, interest, and annuities.
PLR-101009-21                                3


        Section 1362(f) provides, in part, 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
was terminated under § 1362(d)(2) or (3); (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 so that the corporation for which the
election was made or the termination occurred is a small business corporation; and
(4) the corporation for which the election was made or the termination occurred, and
each person who was a shareholder of the corporation at any time during the period
specified pursuant to § 1362(f), agree to make the adjustments (consistent with the
treatment of the corporation as an S corporation) as may be required by the Secretary
regarding this period, then, notwithstanding the circumstances resulting in the
ineffectiveness or termination, the corporation shall be treated as an S corporation
during the period specified by the Secretary.

       Section 1.1362-4(b) provides, in part, that 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, in the
case of a termination, 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 of the election 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 1.1368-1(f)(3) provides that an S corporation may elect under § 1.1368-
1(f)(3) to distribute all or part of its subchapter C accumulated 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 under
§ 1.1368-1(f)(2) (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. In the
case of elections for taxable years beginning after December 31, 2002, the statement
PLR-101009-21                                4

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.

       Section 1375 imposes a tax on the income of an S corporation that has
accumulated earnings and profits at the close of a taxable year, and that has gross
receipts more than 25 percent of which are passive investment income (within the
meaning of § 1362(d)(3)). The tax is computed by multiplying the excess net passive
investment income by the highest rate of tax specified in § 11(b).

       Section 1375(b)(1)(B) provides that the amount of the excess net passive
investment income for any taxable year shall not exceed the amount of the corporation’s
taxable income for such 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.

                                        Conclusion

       Based solely on the representations made and the information submitted, we
conclude that X’s S corporation election terminated on Date 6 under § 1362(d)(3)(A)
because X had subchapter C accumulated earnings and profits at the close of each of
three consecutive taxable years beginning on Date 2, and had gross receipts for each of
those taxable years more than 25 percent of which were passive investment income.
We conclude, however, that the termination was inadvertent within the meaning of
§ 1362(f).

        Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S
corporation on and after Date 6, provided that X’s S corporation election was valid and
is not otherwise terminated under § 1362(d). This ruling is subject to the following
conditions: (1) within 120 days from the date of this letter, X must file an amended
return for Year, electing pursuant to § 1.1368-1(f)(3) to make a deemed dividend
distribution of $a, and (2) within 120 days from the date of this letter, X’s Shareholders
during Year must amend their individual income tax returns for Year to reflect the
changes made to X’s tax return for Year. If these 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 Date 6.

        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 X’s eligibility to be
an S corporation.
PLR-101009-21                                5

       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 who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.

        Under a power of attorney on file with this office, we are sending a copy of this
letter to your authorized representative.


                                          Sincerely,




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



Enclosure
      Copy for § 6110 purposes


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