S corporation election restored after a botched QSST conversion, contingent on a late QSST election

Plain-English summary

A small business corporation taxed as an S corporation ran into the same trap addressed in its companion ruling. When a shareholder died, his stock passed to a testamentary trust, which may hold S corporation stock for only two years unless it becomes a qualified subchapter S trust (a QSST) and the beneficiary files a QSST election. The trustees never moved the stock into the intended QSST and the beneficiary never filed the election, so the trust became an ineligible shareholder and the S election terminated. After catching the mistake, the trustees got a state court to reform the trust, then formed the intended QSST (Trust 2) and transferred the stock to it. The IRS ruled the termination was inadvertent under § 1362(f), so the company keeps S corporation treatment from the termination date forward, provided its election was otherwise valid. Unlike the companion ruling, relief here is contingent: the beneficiary must file the QSST election for Trust 2 (effective the transfer date) within 120 days of this letter.

Ruling snapshot

• Question: Was the termination of the company's S corporation election, caused by a trust becoming an ineligible shareholder, inadvertent so S corporation treatment can continue?
• Outcome: Approved (termination held inadvertent under § 1362(f); contingent on the beneficiary filing a QSST election for Trust 2 within 120 days)
• Key authorities: IRC §§ 1362(f), 1362(d)(2), 1361(c)(2), 1361(d)(3); Treas. Reg. § 1.1361-1(j)(6)(ii); Rev. Rul. 93-79

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224
Number: 202218005
Release Date: 5/6/2022

                                                            Third Party Communication: None

Index Numbers: 1362.00-00, 1362.02-00, Date of Communication: Not Applicable
1362.02-02, 1362.04-00
Person To Contact:
------------------------------------------------------- --------------------, ID No. -----------------
----------------------- Telephone Number:
-------------------------------- --------------------
---------------------------- Refer Reply To:
---------------------------------- CC:PSI:03
PLR-116171-21
Date:
February 03, 2022

Legend

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

State 1 = -------------

State 2 = ---------

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

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

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

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

Date 5 = -------

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

Date 7 = -------------------------

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

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

PLR-116171-21 2

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

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

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

    This letter responds to a letter dated July 16, 2021, and subsequent

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

                                                  Facts

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

1 on Date 1 and elected to be an S corporation effective Date 1. On Date 2, A, a
shareholder of X, died. On Date 3, A’s shares of X were transferred to Trust 1 pursuant
to the terms of A’s will. Trust 1 qualified as a permissible S corporation shareholder
under § 1361(c)(2)(A)(iii) for a 2-year period beginning on Date 3, the day on which X
stock was transferred to it. Pursuant to A’s will, the trustees of Trust 1 were supposed
to have transferred X stock to a separate trust (Trust 2) that was intended to be a
qualified subchapter S trust (QSST) for the benefit of B because the governing
provisions of Trust 1 did not satisfy the QSST requirements under § 1361(d)(3).
However, the trustees of Trust 1 failed to transfer X stock to Trust 2 and B, the income
beneficiary of Trust 2, failed to file a QSST election under § 1361(d)(2) for Trust 2.
Consequently, on Date 4, Trust 1 became an ineligible shareholder of X and X’s S
corporation election terminated.

   In late Date 5, X learned that its S corporation election terminated on Date 4 and

that Trust 1 was an ineligible shareholder. Subsequently, trustees of Trust 1 petitioned
a State 2 court to modify the terms of Trust 1 to ensure it qualified as a QSST effective
Date 3. On Date 6, the State 2 court approved the requested modification. To
effectuate the State 2 court-approved modification, Trust 2 was formed for the benefit of
B and Trust 1 transferred its shares of X stock to Trust 2 on Date 7. It is represented
that Trust 2 satisfies the QSST requirements under § 1361(d)(3).

    X represents that at all relevant times, X and its shareholders have filed federal

tax returns consistent with X being an S corporation. X represents that the termination
of its S corporation election was inadvertent and was not motivated by a tax avoidance
or retroactive tax planning. X and its shareholders agree to make any adjustments
consistent with the treatment of X as an S corporation as may be required by the
Secretary.
PLR-116171-21 3

                                 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)(i) provides that a trust, all of which is treated (under

subpart E of part I of subchapter J of chapter 1) as owned by an individual who is a
citizen or resident of the United States, may be an S corporation shareholder.

   Section 1361(c)(2)(A)(iii) provides that, for purposes of § 1361(b)(1)(B), a trust

with respect to stock transferred to it pursuant to the terms of a will may be an S
corporation shareholder, but only for the two-year period beginning on the day on which
such stock is transferred to it.

   Section 1361(d)(1) provides that a QSST whose beneficiary makes an election

under § 1361(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the
beneficiary of such trust will be treated as the owner (for purposes of § 678(a)) of that
portion of the trust which consists of stock in an S corporation with respect to which the
election under § 1361(d)(2) is made.

     Section 1361(d)(3) defines a QSST as a trust (A) the terms of which require that

(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust; (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary; (iii) the income interest of the
current income beneficiary in the trust shall terminate on the earlier of such beneficiary's
death or the termination of the trust; and (iv) upon termination of the trust during the life
of the current income beneficiary, the trust shall distribute all of its assets to that
beneficiary; and (B) all of the income (within the meaning of § 643(b)) of which is
distributed (or required to be distributed) currently to one individual who is a citizen or
resident of the United States.

   Section 1.1361-1(j)(6)(ii) of the Income Taxation Regulations provides that the

current income beneficiary of the trust must make the election under § 1361(d)(2) by
signing and filing with the service center with which the corporation files its income tax
PLR-116171-21 4

return the applicable form or a statement including the information listed in § 1.1361-
1(j)(6)(ii).

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

terminated whenever the corporation ceases to be a small business corporation. A
termination of an S corporation under § 1362(d)(2) is effective on and after the date of
cessation.

   Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a)

by any corporation was terminated under § 1362(d)(2); (2) the Secretary determines
that the circumstances resulting in the termination were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in the
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
circumstances resulting in the termination, such corporation shall be treated as an S
corporation during the period specified by the Secretary.

   Rev. Rul. 93-79, 1993-2 C.B. 269, provides that a reformation of a trust to meet

the requirements of a QSST is recognized prospectively.

                                    Conclusion

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

that X's S corporation election terminated on Date 4 when Trust 1 became an ineligible
shareholder. We further conclude that the termination of X's S corporation election on
Date 4 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 4 and
thereafter, provided that X's S corporation election was valid and has not otherwise
terminated under § 1362(d).

    This ruling is contingent on B filing a QSST election for Trust 2 effective Date 7

with the appropriate service center within 120 days from the date of this letter. A copy
of this letter should be attached to the QSST election.

      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 Trust 2’s eligibility to be a QSST.

  This ruling is directed only to the taxpayer who requested it. According to

§ 6110(k)(3) of the Code, this ruling may not be used or cited as precedent.
PLR-116171-21 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.

     Pursuant to 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 of letter for § 6110 purposes

cc: