S corporation status restored after trusts missed their ESBT elections

Plain-English summary

A small business corporation elected S corporation status. Later, two shareholders transferred their shares into two trusts. Those trusts could have qualified to hold S corporation stock as Electing Small Business Trusts (ESBTs), but the trustees never filed the required ESBT elections. Without that election, the trusts were ineligible shareholders, and the corporation's S election automatically terminated on the day the shares moved. The corporation asked the IRS to treat the termination as inadvertent under section 1362(f). The IRS agreed: it found the failure inadvertent and ruled that the corporation continues to be an S corporation, so long as the trustees file the missing ESBT elections within 120 days and everyone files returns consistent with that treatment. This matters because losing S status can trigger corporate-level tax and disrupt shareholder reporting; section 1362(f) is the safety valve that lets a company fix an honest paperwork slip rather than lose passthrough treatment.

Ruling snapshot

• Question: Was the termination of the corporation's S election, caused by trustees failing to file ESBT elections, inadvertent under section 1362(f) so that S status can continue?
• Outcome: Approved (inadvertent termination relief granted, subject to conditions)
• Key authorities: IRC § 1362(f); § 1361(e) (ESBT definition and election); § 1361(c)(2); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202205014 Third Party Communication: None
Release Date: 2/4/2022 Date of Communication: Not Applicable
Index Number: 1361.03-03, 1362.04-00
Person To Contact:
------------------------ ----------------------, ID No. -----------------
--------------------- Telephone Number:
---------------------- --------------------
---------------------------- Refer Reply To:
---------------------------------------------------- CC:PSI:B01
PLR-110838-21
Date:
November 03, 2021

                                               LEGEND

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

State = ------

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

B = ---------------------------

Trust 1 = ----------------------------------------------------------------------------------
---------------------------------------

Trust 2 = ----------------------------------------------------------------------------------
---------------------------------------

Date 1 = ------------------------

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

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

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

This responds to a letter dated May 11, 2021, and subsequent correspondence,
submitted on behalf of X by X’s authorized representative, requesting relief under
§ 1362(f) of the Internal Revenue Code (Code).
PLR-110838-21 2

                                      FACTS

The information submitted states that X was incorporated under the laws of State on
Date 1 and elected to be treated as an S corporation on Date 2. On Date 3, A and B,
shareholders of X, transferred shares of X’s outstanding stock to Trust 1 and Trust 2,
respectively. X represents that Trust 1 and Trust 2 each were eligible to make an
Electing Small Business Trust (ESBT) election as of Date 3 and thereafter. However,
the trustees of Trust 1 and Trust 2 failed to file an ESBT election under § 1361(e)(3).
Therefore, Trust 1 and Trust 2 were ineligible shareholders of X and X’s S corporation
election terminated on Date 3.

X represents that the failure to file ESBT elections for Trust 1 and Trust 2 was
inadvertent. Further, X represents that X and its shareholders agree to make any
adjustments (consistent with the treatment of X as an S corporation and Trust 1 and
Trust 2 as ESBTs) that 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(c)(2)(A)(v) provides that, for purposes of § 1362(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.

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 the
trust must make the ESBT election by signing and filing, with the service center where
PLR-110838-21 3

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
qualified subchapter S trust 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)(A) provides that an election under § 1362(a) shall be terminated
whenever (at any time on or after the 1st day of the 1st taxable year for which the
corporation is an S corporation) the corporation ceases to be a small business
corporation.

Section 1362(f) provides, in part, that if: (1) an election under § 1362(a) by any
corporation was terminated under of § 1362(d)(2) or (3), (2) the Secretary determines
that the circumstances resulting in such termination were inadvertent, (3) no later than a
reasonable period of time after discovery of the circumstances resulting in termination,
steps were taken so that the corporation for which the termination occurred is a small
business corporation, and (4) the corporation for which the 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 any adjustments (consistent with the
treatment of the corporation as an S corporation) as may be required by the Secretary
with respect to the period, then, notwithstanding the circumstances resulting in such
termination, such corporation will be treated as an S corporation during the period
specified by the Secretary.

                                  CONCLUSION

Based solely on the facts submitted and representation made, we conclude X’s S
corporation election terminated on Date 3 when Trust 1 and Trust 2 became
shareholders because the trustees of each of Trust 1 and Trust 2 failed to timely file the
required ESBT election. We further conclude that the termination of X’s S corporation
election 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 from Date 3 and
thereafter, provided that X’s S corporation election is not otherwise terminated under
§ 1362(d).

This letter ruling is subject to the following conditions. No later than 120 days from the
date of this letter: (1) the trustees of each of Trust 1 and Trust 2 must file an ESBT
election effective Date 3 with the appropriate service center; and (2) X and its
shareholders (in particular, Trust 1 and Trust 2) must also file any original or amended
returns for all open taxable years consistent with the relief granted in this letter and the
treatment of Trust 1 and Trust 2 as ESBTs. A copy of this letter should be attached to
the ESBT election. If these conditions are not met, then this ruling is null and void. In
addition, if these conditions are not met, X must send notification that its S corporation
PLR-110838-21 4

election has terminated to the service center with which X’s S corporation election was
filed.

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, we express or imply no opinion regarding whether X is
otherwise eligible to be an S corporation or whether Trust 1 and Trust 2 are otherwise
eligible to be an ESBTs.

This ruling is directed only to the taxpayer requesting 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 have sent a copy of
this letter to X’s authorized representative.

                                  Sincerely,

                                  /s/ Caroline E. Hay

                                  Caroline E. Hay
                                  Senior Counsel, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosure:
Copy for 6110 purposes

cc: