S corporation gets relief after a shareholder's exempt status changed and disqualified it

Plain-English summary

A company had elected to be taxed as an S corporation. One of its shareholders was a charity described in § 501(c)(3), which the tax law allows to hold S corporation stock. Later the IRS retroactively reclassified that charity as a § 501(c)(4) organization, a type that is not a permitted S corporation shareholder. That change automatically terminated the company's S election as of the reclassification date. Once the company discovered the problem, it moved the shares to an eligible shareholder. The company asked the IRS to treat the termination as inadvertent under § 1362(f). The IRS agreed, so the company keeps its S corporation status without a gap. This matters because losing S status unexpectedly can trigger corporate-level tax and disrupt shareholder reporting; § 1362(f) relief lets a company fix an accidental slip.

Ruling snapshot

• Question: Was the termination of the company's S election, caused when a shareholder ceased to be an eligible exempt organization, inadvertent under § 1362(f)?
• Outcome: Approved (relief granted; treated as an S corporation continuously)
• Key authorities: IRC § 1362(f); § 1362(d)(2)(A); § 1361(b)(1); § 1361(c)(6); § 501(c)(3)

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202234004                                              Third Party Communication: None
 Release Date: 8/26/2022                                        Date of Communication: Not Applicable
 Index Number: 1362.04-00
                                                                Person To Contact:
 ----------------------------------------------------------     ------------, ID No. -----------------
 ---------------------------------------------                  Telephone Number:
 ------------------------------------------                     --------------------
 ------------------------------------                           Refer Reply To:
 ---------------------------------                              CC:PSI:B03
                                                                PLR-124800-21
                                                                Date:
                                                                June 02, 2022


LEGEND


Company                    =        -----------------------------------------------------------
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X                          =         --------------------------------------------------------------------------------
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Y                          =        -------------------------------

Letter                     =         ------------------------------------------------------------------------------
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State                      =        ----------

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

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

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

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

Year 1                     =        -------

Year 2                     =        -------

Year 3                     =        -------

Year 4                    =   -------


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

      This letter responds to a letter dated November 4, 2021, and subsequent
correspondence, submitted on behalf of Company by its authorized representative
requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                             FACTS

        The information submitted states Company was incorporated on Date 1, under
the laws of State. The Company shareholders filed Form 2553, Election by a Small
Business Corporation, for Company to be an association treated as an S corporation
effective Date 2. X was an organization described in § 501(c)(3) and a shareholder of
Company on Date 2. Pursuant to Letter, X’s § 501(c)(3) status was retroactively
converted to § 501(c)(4) status, effective Date 3. Accordingly, the S corporation
election for Company terminated, effective Date 3, because X became an ineligible S
corporation shareholder. Upon discovering X’s status as an ineligible shareholder,
Company transferred shares of stock owned by X to Y, an eligible shareholder, effective
Date 4.

        Company represents that the circumstances resulting in the termination of
Company’s S corporation election were inadvertent and not motivated by tax avoidance
or retroactive tax planning. Company further represents that X has filed its Exempt
Organization Business Tax Returns on Form 990-T for tax years Year 1, Year 2, Year 3
and Year 4, and has paid its unrelated business income tax reported in those returns.
Company, its shareholders, and X have agreed to make any adjustments that the
Commissioner may require, consistent with the treatment of Company 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) provides that the term "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 one class of stock.

      Section 1361(c)(6) provides that certain exempt organizations are permitted as
shareholders, that is, an organization which is (A) described in § 401(a) or 501(c)(3),
and (B) exempt from taxation under § 501(a).

       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 not effective for the taxable year for which it was made (determined
without regard to § 1362(b)(2)) by reason of a failure to meet the requirements of §
1361(b) or to obtain shareholder consents, (2) the Secretary determines that the
circumstances resulting in such ineffectiveness were inadvertent, (3) no later than a
reasonable period of time after discovery of the event resulting in the ineffectiveness,
steps were taken (A) so that the corporation is a small business corporation, or (B) to
acquire the required shareholder consents, 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 such adjustments (consistent with the treatment
of the 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, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

                                     CONCLUSION

     Based on the facts submitted and representations made, we conclude that
Company’s S election, effective Date 2, was terminated on Date 3. The S election for
Company was terminated because X, an ineligible shareholder, held Company shares.

       We conclude the termination of Company’s S election was inadvertent within the
meaning of § 1362(f). Accordingly, under § 1362(f), Company will be treated as an S
corporation from Date 3, and thereafter, provided Company’s S election is otherwise
valid and has not terminated under § 1362(d).

       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 Company was otherwise a valid S corporation.

       This ruling is directed only to the taxpayer who 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,



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



Enclosure:
      Copy of letter for § 6110 purposes



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