S corporation's election preserved after an interest was transferred to an ineligible shareholder, because the termination was inadvertent

Plain-English summary

An S corporation loses its status if an ineligible shareholder ends up owning stock. Here a company's ownership interests were transferred to a person who was an ineligible shareholder (a nonresident alien is not allowed under § 1361(b)(1)(C)), which inadvertently terminated the S election. The problem was caught during review of a proposed transaction, and by then the ineligible holder had already transferred the entire interest back to eligible S corporation shareholders. The company asked the IRS to treat the termination as inadvertent under § 1362(f). The IRS agreed: it found no tax-avoidance motive, ruled the termination inadvertent, and said the company will be treated as an S corporation continuously from the termination date onward. The relief is conditional on the company and all shareholders reporting consistently with S corporation treatment (passing through income and adjusting basis and distributions under §§ 1366, 1367, and 1368); if they do not, the ruling is void. This kind of relief spares the company from an unintended conversion to a taxable C corporation.

Ruling snapshot

• Question: Was the termination of the company's S corporation election, caused by a transfer to an ineligible shareholder, inadvertent so that S status can be preserved?
• Outcome: approved (inadvertent termination relief granted, subject to consistent reporting)
• Key authorities: IRC § 1362(f); IRC § 1361(b)(1)(C); IRC §§ 1366, 1367, 1368

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202221003 Third Party Communication: None
Release Date: 5/27/2022 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
--------------------------------------------- ------------, ID No. -----------------
--------------------------------------------- Telephone Number:
-------------------------------------------- --------------------
---------------------- Refer Reply To:
--------------------------------- CC:PSI:B03
PLR-119345-21
Date:
March 02, 2022

Legend

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

State = ---------

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

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

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

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

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

This letter responds to a letter dated September 10, 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

According to the information submitted and representations made, X, organized under
the laws of State, made an election to be treated as an S corporation on Date 1. X’s
election was inadvertently terminated effective Date 2, because membership interests in
X were transferred to A, an ineligible shareholder under § 1361(b)(1)(C). On Date 3, A
transferred all of A’s interest in X to eligible S corporation shareholders. The
termination of X’s S corporation election due to the transfer of stock to A, an ineligible
PLR-119345-21 2

shareholder on Date 2, was discovered during a review in connection with a proposed
transaction.

X represents that the termination was not motivated by tax avoidance or retroactive tax
planning. X further represents that for the period beginning Date 2 and through Date 3,
X, X’s shareholders, and A have filed their respective income tax returns consistent with
X’s S corporation election. X, its shareholders, and A have agreed to make any
adjustments that the Secretary may require, consistent with the treatment of X as an S
corporation.

                               Law and Analysis

Section 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

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)(C) provides that a domestic corporation cannot be a “small business
corporation” if the corporation has a non-resident alien as a shareholder.

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 that if (1) an election under § 1362(a) by any corporation was
terminated under § 1362(d)(2) or (3); (2) the Secretary determines that the
circumstances resulting in 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 is a small business corporation, and (4) the corporation,
and each person who was a shareholder of the corporation at any time during the
period specified pursuant to § 1362(f), agrees to make the adjustments (consistent with
the treatment of the corporation as an S corporation) as might be required by the
Secretary regarding this period, then, notwithstanding the circumstances resulting in
termination, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

                                   Conclusion

Based solely on the facts submitted and representations made, we conclude the
existence of an ineligible shareholder under § 1361(b)(1)(C) caused X's S corporation
election to terminate on Date 2. We further conclude that the circumstances resulting in
PLR-119345-21 3

the termination on Date 2, were inadvertent within the meaning of § 1362(f).
Accordingly, under § 1362(f), X will be treated as an S corporation from Date 2, and
thereafter, provided X's S corporation election was otherwise valid and has not
otherwise terminated under § 1362(f).

This ruling is conditioned upon X and all its shareholders treating X as having been an S
corporation from Date 2 to Date 3, and thereafter. Moreover, the shareholders of X
must include their pro rata share of the separately stated and nonseparately computed
items of income, loss, deduction, or credit as provided in § 1366, make any adjustments
to basis as provided in § 1367, and take into account any distributions made by X as
provided in § 1368. If X or its shareholders fail to treat themselves as described above,
this ruling is null and void.

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provision of the
Code, including whether X was otherwise a valid S corporation.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) of the
Code provides that this ruling 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.

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

                                              Sincerely,

                                                    /S/
                                              ______________________________
                                              Richard T. Probst
                                              Senior Technician Reviewer, Branch 3
                                              Office of Associate Chief Counsel
                                              (Passthroughs & Special Industries)

Enclosure:
Copy for § 6110 purposes

cc: