An S corporation's accidental election termination is treated as inadvertent, so S status continues if the trust beneficiary makes a late QSST election

Plain-English summary

An S corporation had a trust among its shareholders. While the trust's grantor was alive, the trust counted as a grantor trust owned by him, which is a permitted S corporation shareholder. When the grantor died, the tax rules gave the trust a two-year grace period to stay eligible. To keep holding the stock after that, the trust's income beneficiary needed to make a qualified subchapter S trust (QSST) election, but nobody filed it. When the two years ran out and the trust still held the stock, the company's S election automatically terminated. The company said the lapse was inadvertent, not tax-motivated, and that everyone had kept filing as though the S election and the QSST were still valid. Under section 1362(f), the IRS can forgive an inadvertent termination. The IRS agreed the termination was inadvertent and ruled the company will be treated as remaining an S corporation without interruption, on the condition that the beneficiary files the missing QSST election within 120 days. This matters because it spares the company and its owners the harsh tax consequences of an accidental loss of S corporation status.

Ruling snapshot

• Question: Was the termination of the corporation's S election, caused by a trust shareholder's failure to make a timely QSST election, inadvertent under section 1362(f)?
• Outcome: Approved (termination ruled inadvertent; S status continues, contingent on a QSST election filed within 120 days)
• Key authorities: IRC § 1362(f); § 1362(d)(2); § 1361(b), (c)(2), (d)

Full text (IRS public release)

 Internal Revenue Service                                          Department of the Treasury
                                                                   Washington, DC 20224

 Number: 202235008                                                 Third Party Communication: None
 Release Date: 9/2/2022                                            Date of Communication: Not Applicable
 Index Numbers: 1362.00-00, 1362.04-00
                                                                   Person To Contact:
 ---------------------------------                                 --------------------, ID No. -----------------
 ------------------------------------------                        Telephone Number:
 ----------------                                                  --------------------
 -------------------------------------                             Refer Reply To:
 ---------------------------------                                 CC:PSI:03
                                                                   PLR-124894-21
                                                                   Date:
                                                                   June 7, 2022




LEGEND:

X:                 ---------------------------------------
-----------------------------------------

State:            ------------

Date 1:           ---------------------

Date 2:           -------------------

Date 3:           -------------------

Date 4:           -------

Trust:             ---------------------------------------------
-----------------------------------------

A:                ---------------------

B:                -------------------
-----------------------------------------

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

       This letter responds to a letter dated August 17, 2021, and subsequent
correspondence submitted on behalf of X by X's authorized representative, requesting a
ruling under § 1362(f) of the Internal Revenue Code (the Code).

                                          FACTS

        According to the information submitted and representations made, X, a State
corporation, elected to be an S corporation effective Date 1. Trust owned shares of
stock in X. Trust was treated under subpart E of part I of subchapter J of chapter 1 as
entirely owned by A and, thus, was a permissible shareholder of X under
§ 1361(c)(2)(A)(i). On Date 2, A died and Trust ceased to be a permissible shareholder
under § 1361(c)(2)(A)(i). Under § 1361(c)(2)(A)(ii), Trust remained an eligible
shareholder for a 2-year period beginning on the day of A's death. X represents that as
of Date 2, Trust satisfied the qualified subchapter S trust (QSST) requirements under
§ 1361(d)(3). However, B, Trust's income beneficiary, failed to make an election under
§ 1361(d)(2) to treat Trust as a QSST effective Date 2. In Date 4, X learned that its S
corporation election terminated on Date 3 when Trust continued to hold shares of stock
in X after the 2-year period in § 1361(c)(2)(A)(ii) ended.

        X represents that the circumstances resulting in the termination of its S
corporation election were inadvertent and were not motivated by tax avoidance or
retroactive tax planning. Further, notwithstanding its termination on Date 3, X represents
that it and its shareholders have filed tax returns consistent with the treatment of X as
an S corporation and Trust as a QSST since Date 2. Finally, 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.

                                  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, for purposes of § 1361(b)(1)(B), 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 a shareholder of
an S corporation.

       Section 1361(c)(2)(A)(ii) provides that for purposes of § 1361(b)(1)(B), a trust
which was described in § 1361(c)(2)(A)(i) immediately before the death of the deemed
owner and which continues in existence after such death may be an S corporation
shareholder, but only for the 2-year period beginning on the day of the deemed owner's
death.

        Section 1361(d)(1) provides that in the case of a QSST with respect to which a
beneficiary makes an election under § 1361(d)(2) — (A) such trust shall be treated as a
trust described in § 1361(c)(2)(A)(i), (B) for purposes of § 678(a), the beneficiary of such
trust shall be treated as the owner 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, and
(C) for purposes of applying §§ 465 and 469 to the beneficiary of the trust, the
disposition of the S corporation stock by the trust shall be treated as a disposition by
such beneficiary.

      Section 1361(d)(2) provides that a beneficiary of a QSST (or his legal
representative) may elect to have § 1361(d) apply.

         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 the termination of the trust during the
life of the current income beneficiary, the trust shall distribute all of its assets to such
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 1362(d)(2)(A) provides that an election under § 1362(a) will be
terminated whenever (at any time on or after the first day of the first 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 was 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 the
termination, steps were taken so that the corporation for which the termination occurred
is once more a small business corporation, and (4) the corporation for which the
termination occurred and each person who was a shareholder in the corporation at any
time during the period specified pursuant to § 1362(f), agrees to make adjustments
(consistent with the treatment of the corporation as an S corporation) as may be
required by the Secretary with respect to the period, then, notwithstanding the
circumstances resulting in the termination, the corporation will 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 X's S corporation election terminated on Date 3 when Trust became an ineligible
shareholder. We also conclude that the termination was inadvertent within the meaning
of § 1362(f). Accordingly, pursuant to the provisions of § 1362(f), X will be treated as
continuing to be an S corporation from Date 3 and thereafter, provided that X's S
corporation election was valid and was not otherwise terminated under § 1362(d).

        This ruling is contingent on B filing a QSST election for Trust effective Date 2,
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's eligibility to be a QSST.

      This ruling is directed only to the taxpayer that requested it. According to
§ 6110(k)(3) of the Code, 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 representatives.


                                                  Sincerely,



                                                  Mary Beth Carchia
                                                  Senior Technician Reviewer, Branch 3
                                                  Office of the Associate Chief Counsel
                                                  (Passthroughs & Special Industries)




Enclosure:
      Copy of this letter for § 6110 purposes


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