IRS grants relief for an S corporation whose S status lapsed when trust shareholders missed their QSST elections

Plain-English summary

An S corporation can lose its special tax status if an ineligible shareholder
holds its stock. Here, four trusts acquired the company's stock and each
qualified as a qualified subchapter S trust (QSST), but the trusts' income
beneficiaries never filed the required QSST elections on time, which made the
trusts ineligible shareholders and terminated the company's S corporation
status. The company asked the IRS for relief under IRC § 1362(f), which lets the
IRS overlook an inadvertent termination if the lapse was not tax-motivated,
steps were taken to fix it, and everyone agrees to consistent tax treatment. The
IRS found the termination inadvertent and granted relief: the company will be
treated as an S corporation without interruption, and each trust is treated as a
QSST for the relevant period. The IRS did not rule on whether the company is
otherwise eligible to be an S corporation or on whether an earlier merger
qualified as an (F) reorganization.

Ruling snapshot

• Question: Was the termination of the company's S corporation election
  inadvertent, warranting relief under IRC § 1362(f)?
• Outcome: approved (relief granted; S status preserved)
• Key authorities: IRC §§ 1362(f), 1361(d) (QSST); Rev. Rul. 64-250;
  Rev. Rul. 73-526

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202228013 Third Party Communication: None
Release Date: 7/15/2022 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
----------------------------- --------------------------, ID No. ----------------
------------------------------ Telephone Number:
---------------------------------------- --------------------
----------------------------- Refer Reply To:
------------------------------------------------------------ CC:PSI:B01
---- PLR-121489-21
Date:
April 15, 2022

                                               LEGEND

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

Y = ----------------------------------

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

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

C = ------------------------------------------------------------------------------------------------
-------------------------

D = ------------------------------------------------------------------------------------------------
--------------------------

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

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

Trust 3 = ---------------------------------------------------------------------------------------------
PLR-121489-21 2

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

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

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

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

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

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

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

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

This responds to a letter dated October 15, 2021, and supplemental correspondence,
submitted on behalf of X by X's authorized representative, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code).

                                                 FACTS

The information submitted states that X was incorporated under the laws of State 1 on
Date 1. X filed a timely election under § 1362(a) of the Code to be taxed as an S
corporation effective Date 1. In Year, Y was formed under the laws of State 2 as a
limited liability company. Effective Date 2, X merged into Y in what is described as a
§ 368(a)(1)(F) reorganization with Y surviving the merger. Y then changed its name to X
and elected under § 301.7701-3 of the Procedure and Administration Regulations to be
treated as an association taxable as a corporation for federal tax purposes effective
Date 2.

On Date 3, Trust 1, Trust 2, Trust 3, and Trust 4 acquired shares of X stock. X
represents that Trust 1, Trust 2, Trust 3, and Trust 4 each met the requirements of a
qualified subchapter S trust (QSST) within the meaning of § 1361(d)(3). However, the
income beneficiaries of Trust 1, Trust 2, Trust 3, and Trust 4 (A, B, C, and D,
respectively) each failed to timely file an election under § 1361(d)(2) for their respective
trust to be a QSST. Consequently, Trust 1, Trust 2, Trust 3, and Trust 4 were ineligible
shareholders of X and X's S corporation status was terminated.

On Date 4, the trustees of Trust 1, Trust 2, Trust 3, and Trust 4 each distributed all of
their shares X stock to a separate respective trust, each of which is treated (under
PLR-121489-21 3

subpart E of part I of subchapter J of chapter 1 of the Code) as a grantor trust owned by
A, B, C, and D, respectively.

X represents that the circumstances resulting in the termination of X’s S corporation
election were not motivated by tax avoidance or retroactive tax planning considerations.
Additionally, X represents that X and its shareholders have filed their federal income tax
returns consistent with having a valid S corporation election in effect for X. X represents
that from Date 3 until Date 4, A, B, C, and D have each filed federal income tax returns
consistent with being treated as the owner (for purposes of § 678(a)) of the portion of
Trust 1, Trust 2, Trust 3, and Trust 4, respectively, which consists of the X stock. X and
its shareholders have agreed to make any adjustments consistent with the treatment of
X as an S corporation as may be required by the Secretary with respect to the period
specified by § 1362(f).

                               LAW AND ANALYSIS

Section 1361(a)(1) of the Code 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 1
class of stock.

Section 1361(c)(2)(A)(i) provides that for purposes of § 1361(b)(1)(B), a trust all of
which is treated (under subpart E of part 1 of subchapter J of Chapter 1) as owned by
an individual who is a citizen or resident of the United States may be a shareholder.

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 shall be treated as the owner (for purposes of § 678(a)) of that portion of
the QSST which consists of S corporation stock to which an election under § 1361(d)(2)
applies. Section 1361(d)(2) provides that a beneficiary of a QSST may elect to have
§ 1361(d) apply. Under § 1361(d)(2)(D), this election will be effective up to 15 days and
2 months before the date of the election.

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 beneficiary in the trust shall terminate on the earlier of the beneficiary's death or
the termination of the trust; and (iv) upon the termination of the trust during the life of the
PLR-121489-21 4

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 Tax Regulations, provides that the current
income beneficiary of the trust must make the election by signing and filing with the
service center with which the corporation files its income tax the applicable form or a
statement including the information listed in § 1.1361-1(j)(6)(ii).

Section 1362(d)(2) provides that an election under § 1362(a) shall be terminated
whenever (at any time on or after the first day of the taxable year for which a
corporation is an S corporation) such corporation ceases to be a small business
corporation. A termination of an S corporation election 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 not effective for the taxable year for which made (determined without
regard to § 1362(b)(2)) by reason of a failure to meet the requirements of § 1361(b) or
was terminated under § 1362(d)(2) or (3); (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 so that the corporation for which
the election was made or termination occurred is a small business corporation; and (4)
the corporation for which the election was made or 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 such
ineffectiveness or termination, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

Rev. Rul. 64-250, 1964-2 C.B. 333, concludes that when an S corporation merges into a
newly formed corporation in a transaction qualifying as a reorganization under
§ 368(a)(1)(F), and the newly formed surviving corporation also meets the requirements
of an S corporation, the reorganization does not terminate the S election. Thus, the S
election remains in effect for the new corporation.

Rev. Rul. 73-526, 1973-2 C.B. 404, concludes that the identifying number previously
assigned to the transferor corporation should be used by the surviving corporation in a
statutory merger qualifying as a reorganization under § 368(a)(1)(F).
PLR-121489-21 5

                                  CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that X's
S corporation status inadvertently terminated within the meaning of § 1362(f) on Date 3
when Trust 1, Trust 2, Trust 3, and Trust 4 became ineligible shareholders. Pursuant to
the provisions of § 1362(f), X will be treated as an S corporation from Date 3 and
thereafter, provided X's S corporation election is otherwise effective and not terminated
under § 1362(d). In addition, Trust 1, Trust 2, Trust 3, and Trust 4 will be each be
treated as a QSST from Date 3 until Date 4.

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. We also express no opinion on whether X's merger into Y qualifies as a
§ 368(a)(1)(F) reorganization.

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.

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

                                  Sincerely,


                                  _________/s/ _________________

                                  Jennifer N. Keeney
                                  Senior Counsel, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosure:
Copy of this letter for § 6110 purposes

cc: