An S corporation's election is saved after one shareholder trust was mismanaged and eight others missed their ESBT elections

Plain-English summary

An S corporation can only have eligible shareholders, and trusts that hold its stock generally must qualify as grantor trusts or file "electing small business trust" (ESBT) elections. Here the company's S election was jeopardized two ways: the first shareholder trust was supposed to be administered as a grantor trust (the trust agreement required segregating the S corporation stock), but the trustees did not follow that provision; and gifts of stock to eight other trusts required ESBT elections that were never timely filed. Either problem could have made the election invalid from the start or terminated it. The company represented the failures were inadvertent and not tax-motivated, and asked for relief under section 1362(f). The IRS agreed and ruled the company will be treated as continuing to be an S corporation from its original effective date, provided the eight trusts file their ESBT elections within 120 days, a specified payment is made, and consistent returns are filed. This rescues the company's pass-through tax status despite a tangle of trust paperwork errors.

Ruling snapshot

• Question: Were the ineffectiveness/termination of the company's S election, caused by one trust's mismanagement and eight trusts' missing ESBT elections, inadvertent under section 1362(f)?
• Outcome: Approved (ruled inadvertent; S corporation status continues from the original date, contingent on filing the ESBT elections, a required payment, and consistent returns).
• Key authorities: IRC § 1362(f); IRC §§ 1361(b), 1361(c)(2), 1361(e); Treas. Reg. § 1.1361-1(m).

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202207007                                              Third Party Communication: None
 Release Date: 2/18/2022                                        Date of Communication: Not Applicable
 Index Number: 1361.00-00, 1361.03-00,
               1361.03-03, 1362.00-00,                          Person To Contact:
               1362.02-00, 1362.02-02,                          -----------------, ID No. ---------------
               1362.04-00                                       Telephone Number:
                                                                --------------------
 -----------------------------------------                      Refer Reply To:
 ------------------------------------                           CC:PSI:01
 ----------------------------------                             PLR-118737-20
 -----------------------------                                  Date: November 17, 2021




          Legend:



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

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

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

Trust 3           =         -------------------------------------
--------------------------------------------------

Trust 4           =         ------------------------------------------
--------------------------------------------------

Trust 5           =         ---------------------------------------------
--------------------------------------------------

Trust 6           =         ------------------------------------------
--------------------------------------------------

Trust 7           =         -------------------------------------
--------------------------------------------------

Trust 8           =         -------------------------------------
--------------------------------------------------

Trust 9           =        ---------------------------------------
PLR-118737-20                                               2

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

Date 1            =        -------

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

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

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

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

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

State             =        ---------

$n                =        ------------




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

This responds to a letter dated August 24, 2020, requesting relief under section 1362(f)
of the Internal Revenue Code (the Code).

                                                         Facts

According to the information submitted and representations within, X was incorporated
on Date 1, under the laws of State. Effective Date 2, X elected to be taxed as an S
corporation.

On Date 2, Trust 1 became a shareholder of X. Taxpayer represents that it believes
that its accountants believed that Trust 1 was a grantor trust because the trust
agreement required that the trustee segregate any S corporation stock from the
remainder of the trust and hold it for the benefit of each primary beneficiary. When X
made its S election, the trustees of Trust 1 did not follow the provisions of the trust
agreement.

X represents that gifts made to Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust
8, and Trust 9 on Date 3, Date 4, Date 5, or Date 6 may have caused them to become
ineligible S corporation shareholders and that timely elections to treat each of them as
an Electing Small Business Trust (ESBT) were not made, causing X's S corporation
election to terminate.
PLR-118737-20                                 3

X represents that Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, and Trust 9
have at all times, met the requirements of an ESBT within the meaning of section
1361(e), except that the trustees did not make a timely ESBT election under section
1361(e)(3).

X represents that upon discovering that its S election was invalid or had terminated, X
took corrective action by filing this request for relief. X represents that the circumstances
resulting in the invalid election or inadvertent termination and the failure to make timely
ESBT elections was inadvertent and not motivated by tax avoidance or retroactive tax
planning. X further represents that X has filed its income tax returns consistent with
having a valid S election in effect for all taxable years since X elected to be an S
corporation. X represents that, other than the failure to administer Trust 1 according to
its trust agreement, or make a valid ESBT elections, X has qualified as a small business
corporation at all times since its election on Date 2. Lastly, X and its shareholders agree
to make any adjustments required as a condition of obtaining relief under § 1362(f) that
may be required by the Secretary.

X requests three rulings. First, the ineffectiveness of the X’s S election caused by failing
to execute the terms of the trust agreement of Trust 1 was inadvertent, as was the
potential termination of X due to failure to make ESBT elections for Trust 2, Trust 3,
Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, and Trust 9, within the meaning of § 1362(f),
and X will be treated as an S corporation from Date 2 and thereafter.

                                     Law and Analysis

Section 1361(a) provides that an S corporation is a small business corporation for which
an election under § 1362(a) is in effect.

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) provides that the terms “small business corporation” means 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 1361(c)(2)(A)(i) provides that for purposes of section 1361(b)(1) a trust all of
which is treated (under subpart E of part I of subchapter J of this chapter) as owned by
an individual who is a citizen or resident of the United States may be an S corporation
shareholder.
PLR-118737-20                                  4

Section 1361(c)(2)(A)(iii) provides that a trust with respect to stock transferred to it,
pursuant to the terms of a will, is a permissible shareholder for the two year period
beginning on the day on which the stock is transferred to it.

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

Section 1361(e) 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)(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) 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(a) provides that a small business corporation may elect to be an S
corporation.

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) such corporation ceases to be a small business
corporation.

Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a) by any
corporation terminated under § 1362(d)(2); (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 such
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 in such corporation at any time
during the period specified pursuant to § 1362(f), agrees to make the adjustments
(consistent with the treatment of such corporation as an S corporation) as may be
required by the Secretary with respect to such period, then, notwithstanding the
PLR-118737-20                                 5

circumstances resulting in such termination, such corporation shall be treated as an S
corporation during the period specified by the Secretary.

                                        Conclusion

Based solely on the facts submitted and the representations made, we conclude that
the failure to administer Trust 1 in accordance with its trust agreement, and the failure of
Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, and Trust 9 to make ESBT
elections, caused X’s S corporation to be ineffective or to inadvertently terminate 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 and after Date 2, unless X’s S
corporation election is otherwise terminated under § 1362(d).

This letter ruling is subject to the condition that within 120 days from the date of this
letter, elections to treat each of Trust 3, Trust 4, Trust 5, and Trust 6 as an ESBT
effective Date 5, an election to treat Trust 2 as an ESBT effective Date 6, and elections
to treat each of Trust 7, Trust 8, and Trust 9 as an ESBT effective Date 4 must be made
with the appropriate service center. As an adjustment under § 1362(f)(4), a payment of
$n attached with a copy of this letter and sent to the following address within 45 days
from the date of this letter: Internal Revenue Service, Kansas City Submission
Processing Campus, 333 W. Pershing Road, Kansas City, MO 64108, Stop 7777, Attn:
Manual Deposit. A copy of this letter should also be attached to the ESBT elections. If
these conditions are not met, then this ruling is null and void. Furthermore, if these
conditions are not met, X must send notification that its S election has terminated to the
service center with which X’s S election was filed.

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation, or whether Trust 1 was or is otherwise eligible to be a grantor trust, or
whether any of Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, and Trust 9
was or is otherwise eligible to be an ESBT.

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.
PLR-118737-20                                6

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 and Special Industries)

Enclosure:
      Copy for § 6110 purposes

cc: