A company that repeatedly blew its S corporation status through partnership conversions and missed trust elections gets inadvertent-termination relief under section 1362(f)

Plain-English summary

An S corporation gets pass-through tax treatment only if it stays a "small business corporation," which among other things means it can have just one class of stock and only eligible shareholders (certain trusts count only if the trustee makes the right election). Here a company elected S status, then over several years tripped every wire: it converted into a limited partnership (whose agreement's capital-account and liquidation provisions may have created a prohibited second class of stock), an owner gifted interests to several trusts whose trustees never made the required Electing Small Business Trust (ESBT) elections, and one wholly owned entity flipped from disregarded to a partnership, making it an ineligible shareholder. Any of these would have terminated the company's S election. The company represented that all of it was inadvertent, not tax-motivated, and once it discovered the problems it unwound the bad structures and consolidated ownership into eligible hands. The IRS granted relief under section 1362(f): the company is treated as having continued as an S corporation throughout, provided the trustees file the missing ESBT elections within 120 days, the trusts amend returns for open years, and the company sends a specified payment within 45 days. If those conditions are not met, the ruling is void. The takeaway is that section 1362(f) can rescue an S election from multiple accidental terminations at once, but only on strict corrective conditions.

Ruling snapshot

• Question: Were the terminations of the company's S corporation election (from a possible second class of stock and from ineligible trust/partnership shareholders) inadvertent, so that section 1362(f) relief should be granted?
• Outcome: Approved (inadvertent-termination relief granted; S status treated as continuous, conditioned on late ESBT elections, amended returns, and a required payment)
• Key authorities: IRC §§ 1362(f), 1362(d)(2), 1361(b)(1), 1361(e); Treas. Reg. § 1.1362-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202244001 Third Party Communication: None
Release Date: 11/4/2022 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
Person To Contact:
-------------------------------------- ----------------------, ID No. -----------------
------------------------------------------ Telephone Number:
-------------------- --------------------
----------------------- Refer Reply To:
----------------------------- CC:PSI:B01
PLR-102857-22
Date:
August 02, 2022

                                             Legend

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

State = --------

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

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

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

Z = -------------------

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

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

Trust 3 = ------------------------------------------------
------------------------

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

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

Date 2 = ----------------------
PLR-102857-22 2

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

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

Date 5 = -------------------

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

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

Date 8 = -------------------------

$n = ------------------------------------------------
----------------------------------------------

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

This letter responds to a letter dated December 28, 2021, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
relief under § 1362(f) of the Internal Revenue Code (Code).

                                               Facts

According to the information submitted and representations made, X was incorporated
under the laws of State. X elected to be treated as an S corporation effective Date 1.
At that time, X’s only shareholders were individuals A and B.

On Date 2, X converted from a State corporation to a State limited partnership, and filed
a Form 8832, Entity Classification Election, to be classified as an association taxable as
a corporation effective Date 2. X represents that the conversion qualified as a
reorganization under § 368(a)(1)(F) and X therefore continued as an S corporation.
After the conversion, X’s limited partners were A and B and X’s general partners were Y
and Z. Y and Z were both limited liability companies formed under the laws of State
treated as entities disregarded from A and B, respectively, for federal tax purposes.

Effective Date 3, the partners of X entered into a new partnership agreement, Revised
Partnership Agreement. This agreement contained provisions in contemplation of X
being treated as a partnership for federal income tax purposes, including that capital
accounts be maintained and that liquidating distributions of the partnership be made in
accordance with the partners’ positive capital account balances.

The conversion on Date 2 to a State limited partnership may have created a second
class of stock in violation of the one class of stock requirement under § 1361(b)(1)(D),
thereby possibly causing X’s S corporation election to terminate. In addition, the
PLR-102857-22 3

provisions in the Revised Partnership Agreement gave rise to a second class of stock
causing X’s S corporation election, if not otherwise terminated, to terminate on Date 3.
However, X represents that any second class of stock was created inadvertently.

On Date 4, A gifted A’s limited partnership interest in X to Trust 1, Trust 2, and Trust 3.
Also on Date 4, A gifted A’s interest in Y to Trust 1 and Trust 2. Because of this
transfer, Y changed from being treated as a disregarded entity to being treated as a
partnership. On Date 5, Trust 3 merged with and into Trust 4. As a result of this
merger, Trust 3’s interest in X became the property of Trust 4.

X represents that Trust 1, Trust 2, Trust 3, and Trust 4 each met the definition of an
Electing Small Business Trust (ESBT) under § 1361(e)(1). However, the respective
trustees failed to make timely ESBT elections for the trusts under § 1361(e)(3). As a
result, X had ineligible shareholders in violation of § 1361(b)(1)(B) and X’s S corporation
election would have terminated on Date 4 and Date 5. However, X represents that the
failure to make ESBT elections was inadvertent.

X also represents that when A’s interest in Y was gifted to Trust 1 and Trust 2 on Date
4, Y converted from being treated as a disregarded entity to being treated as a
partnership for federal tax purposes and therefore was an ineligible shareholder under
§ 1361(b)(1)(B), also causing X’s S corporation election to terminate on Date 4.
However, X represents that it was unaware of that consequence of the transfer and that
the change to a partnership was inadvertent.

Upon discovering that it had ineligible shareholders and more than one class of stock, X
took the following actions:

On Date 6, Y’s general partnership interest was converted to a limited partnership
interest and was distributed out to Trust 1 and Trust 2 such that Y was no longer a
shareholder. Also on Date 6, Z’s general partnership interest was converted to a limited
partnership interest and distributed out to B such that Z was no longer a shareholder. In
addition, language contained in the Revised Partnership Agreement in contemplation of
X being treated as a Partnership for federal tax purposes was removed and new
language contemplating X being treated as an S corporation for federal tax purposes
was inserted.

On Date 7, Trust 1 purchased Trust 4’s limited partnership interest in X and also
purchased a portion of B’s limited partnership interest in X. Also on Date 6, Trust 2
purchased a portion of B’s limited partnership interest in X. After these purchases,
Trust 1, Trust 2, and B were the only remaining shareholders of X.

Effective Date 8, X converted from a State limited partnership to a State limited liability
company. X filed a Form 8832, Entity Classification Election, to be classified as an
association taxable as a corporation effective Date 8.
PLR-102857-22 4

X represents that there was no intent to terminate X's S corporation election and the
inadvertent terminations were not motivated by tax avoidance or retroactive tax
planning. X and its shareholders have consistently treated X as an S corporation since
Date 1 and 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)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT may
be a shareholder.

Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), the term
“electing small business trust” means any trust if (i) such trust does not have as a
beneficiary any person other than (I) an individual, (II) an estate, (III) an organization
described in § 170(c)(2)-(5), or (IV) an organization described in § 170(c)(1) which holds
a contingent interest in such trust and is not a potential current beneficiary, (ii) no
interest in such trust was acquired by purchase, and (iii) an election under
§ 1361(e) applies to such trust.

Section 1361(e)(3) provides that an election under § 1361(e) shall be made by the
trustee. Any such election shall apply to the taxable year of the trust for which made and
subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

Section 1.1361-1(l)(1) provides, in part, that a corporation is generally treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds.

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 taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation. Section 1362(d)(2)(B) further provides that the termination shall be effective
on and after the date of cessation.
PLR-102857-22 5

Section 1362(f) provides, in part, 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 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 of the corporation at any time during
the period specified pursuant to § 1362(f), agree to make the adjustments (consistent
with the treatment of the corporation as an S corporation) as may be required by the
Secretary regarding this period, then, notwithstanding the circumstances resulting in the
termination, the corporation shall be treated as an S corporation during the period
specified by the Secretary.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that
are appropriate. In general, the adjustments required should be consistent with the
treatment of the corporation as an S corporation during the period specified by the
Commissioner.

                                    Conclusion

Based solely on the representations made and the information submitted, we conclude
that if X's conversion from a State corporation to a State limited partnership on Date 2
did create a second class of stock, the consequent termination of X's S corporation
election was inadvertent within the meaning of 1362(f). We further conclude that X’s S
corporation election, if not otherwise terminated, would have terminated on Date 3
because the partnership provisions created a second class of stock. In addition, we
conclude that X's S corporation election, if not otherwise terminated, would have
terminated on Date 4 because it had ineligible shareholders under § 1361(b)(1)(B)--Y
became a partnership and was therefore an ineligible shareholder and the trustees of
Trust 1, Trust 2, and Trust 3, failed to make ESBT elections thus the trusts were
ineligible shareholders. Finally, the election also would have terminated on Date 5
when Trust 3 merged into Trust 4 because the trustee of Trust 4 failed to make an
ESBT election. However, we also conclude that such terminations were 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 beginning on and after Date 2, unless X’s S
corporation election is otherwise terminated under § 1362(d).

This ruling is contingent on: (1) the trustees of Trust 1 Trust 2, and Trust 3 filing within
120 days from the date of this letter ESBT elections effective Date 4 on behalf of their
respective trusts with the appropriate service center; (2) the trustees of Trust 4 filing
within 120 days from the date of this letter an ESBT election effective Date 5 on behalf
of Trust 4 with the appropriate service center; and (3) Trust 1, Trust 2, and Trust 4 filing
within 120 days from the date of this letter amended returns for all open years to
properly reflect the treatment of Trust 1, Trust 2, and Trust 4 as ESBTs. A copy of this
letter must be attached to any ESBT elections and income tax returns to which it is
relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
PLR-102857-22 6

requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

Furthermore, as an adjustment under § 1362(f)(4), a payment of $n and a copy of this
letter must be sent within 45 days from the date of this letter to the following address:
Internal Revenue Service, Kansas City Submission Processing Campus, Attn: Manual
Deposit, 333 W. Pershing Road, Stop 7777, Kansas City, MO 64108.

If the above conditions are not met, then this ruling is null and void. Furthermore, if
these conditions are not met, X must notify the service center with which it filed its S
corporation election that its election terminated.

The rulings contained in this letter are 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 request for rulings, it is subject to verification on examination.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, no opinion is expressed or implied regarding X's eligibility to be
an S corporation or Trust 1, Trust 2, or Trust 3's eligibility to be ESBTs.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

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

                                   Sincerely,


                                   _______________________________
                                   Caroline E. Hay
                                   Senior Technician Reviewer, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosure (1)
Copy for § 6110 purposes

cc: