S corporation's election, ended when an interest was sold to a partnership, is restored as an inadvertent termination

Plain-English summary

An LLC that had elected to be taxed as an S corporation had one of its members sell part of its interest to another LLC that is treated as a partnership. A partnership is not an eligible S corporation shareholder, so that sale automatically terminated the company's S election. After discovering the problem, the company had the partnership distribute its interests out to individual members, all of whom are eligible shareholders. It then asked the IRS for relief under section 1362(f), which lets the IRS treat a terminated S election as if it never lapsed when the termination was inadvertent and the parties fix it. The company represented the miss was inadvertent and not tax-motivated. The IRS agreed the termination was inadvertent and ruled the company continues to be treated as an S corporation from the termination date forward, provided the election was otherwise valid. It matters because it saves a company from an unexpected shift to C corporation taxation caused by a stock sale to an ineligible owner.

Ruling snapshot

• Question: Was the termination of the company's S election, caused by selling an interest to a partnership, an inadvertent termination that can be excused?
• Outcome: Approved (S status restored from the termination date, subject to the standard conditions)
• Key authorities: IRC §§ 1361(b), 1362(a), 1362(d)(2), 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202147002 Third Party Communication: None
Release Date: 11/26/2021 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-01,
1362.02-00 Person To Contact:
--------------, ID No. -----------------
------------------------------------ Telephone Number:
-------------------------------------- ---------------------
---------------------- Refer Reply To:
------------------------------- CC:PSI:B01
PLR-104184-21
Date:
August 17, 2021

Legend

X = ---------------------------------
----------------------
---------------------------------
LLC = --------------------------------
Y = ----
Z = ---
Date 1 = -----------------------
Date 2 = ----------------
Date 3 = ------------------------
Date 4 = -----------------------
State = ------------
A = ---------------------------------
------------------------
B = ---------------------------------
---------------------------------
C = ---------------------------------
---------------------------------
D = ---------------------------------
---------------------------------
E = ---------------------------------
---------------------------------
F = ---------------------------------
---------------------------------

Dear ----------------:
PLR-104184-21 2

    This letter responds to a letter dated February 22, 2021, submitted on behalf of X

by its authorized representatives, requesting inadvertent termination relief under § 1362(f)
of the Internal Revenue Code (Code).
Facts

     The information submitted discloses that X was formed on Date 1 as a limited

liability company under the laws of State and elected to be an S corporation effective Date
1.
On Date 2, A sold Y% of the membership interest in X to B, an individual and Z%
of the membership interest in X to LLC, a partnership for federal tax purposes. LLC, as a
partnership, was an ineligible shareholder of an S corporation. On or about Date 3, X
learned that the sale of X interest to LLC terminated X’s S corporation election. On Date
4, X and its shareholders took remedial action by having LLC distribute all of its interests
in X to A, C, D, E, and F, individual members. X represents that A, B, C, D, E, and F, are
eligible S corporation shareholders.

   X represents that the circumstances resulting in the termination of X’s S

corporation election were inadvertent and not motivated by tax avoidance or retroactive
tax planning. X further represents that X and its members have agreed to make any
adjustments the Commissioner may require, consistent with the treatment of X as an S
corporation.

                                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 the 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 1
class of stock.

  Section 1362(d)(2)(A) provides that an election under § 1362(a) shall be

terminated whenever (at any time on or after the 1st day of the taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

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

1361(b)(3)(B)(ii) by any corporation (A) was not effective for the taxable year for which
made (determined without regard to subsection (b)(2)) by reason of a failure to meet the
requirements of section 1361(b) or to obtain shareholder consents, or (B) was terminated
under paragraph (2) or (3) of subsection (d) or section 1361(b)(3)(C); (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
PLR-104184-21 3

that the corporation for which the election was made or the termination occurred is a small
business corporation or a qualified subchapter S subsidiary, as the case may be, or (B)
to acquire the required 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 this subsection,
agrees to make such adjustments (consistent with the treatment of such corporation as
an S corporation or a qualified subchapter S subsidiary, as the case may be) 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 or a qualified subchapter S subsidiary, as the case may be
during the period specified by the Secretary.

                                    Conclusion

   Based solely on the information submitted and the representations made, we

conclude that X’s S corporation election terminated on Date 2 when an interest in X was
sold to LLC. We further conclude that the termination was inadvertent within the meaning
of § 1362(f). Accordingly, under § 1362(f), X will be treated as continuing to be an S
corporation on and after Date 2, provided that X’s S corporation election was valid and
not otherwise terminated under § 1362(d).

  Except as specifically ruled above, we express or imply no opinion as to the federal

income tax consequences of the facts described above under any other provision of the
Code. Specifically, no opinion is expressed concerning whether X is a subchapter S
corporation for federal purposes.

  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.

   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.
PLR-104184-21 4

    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,



                                  Laura Fields
                                  Laura Fields
                                  Chief, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosure
Copy for 6110 purposes

cc: