Inadvertent invalid S election relief where an IRA held the stock

Plain-English summary

A company elected to be taxed as an S corporation, which passes income through to
its shareholders. S corporations may only have eligible shareholders. From the
very start, though, some of the company's stock was held by an individual
retirement account (an IRA), which is not an eligible S-corporation shareholder.
That made the S election invalid from day one, and neither the shareholder nor
the company realized it at the time. Once they discovered the problem, the IRA
distributed its shares to the individual. The company asked the IRS for relief
under Code § 1362(f), which lets the IRS overlook an inadvertent defect. The IRS
agreed the invalid election was inadvertent and treated the company as an S
corporation from the start, subject to conditions: for closed-out gain and loss
years the IRA or the individual is treated as the shareholder as specified, and
the company must make a required payment within 45 days. This matters because
holding S-corporation stock in an IRA quietly breaks the S election, and § 1362(f)
is the route to fix it when the mistake was honest.

Ruling snapshot

• Question: Was a company's S election, invalid from the start because an IRA held its stock, an inadvertent defect that can be excused under § 1362(f)?
• Outcome: approved (relief granted, subject to shareholder-attribution and payment conditions)
• Key authorities: IRC § 1362(f); IRC § 1361(b); IRC §§ 1366, 1367, 1368

Full text (IRS public release)

     Internal Revenue Service                                      Department of the Treasury
                                                                   Washington, DC 20224

     Number: 202319003                                             Third Party Communication: None
     Release Date: 5/12/2023                                       Date of Communication: Not Applicable
     Index Number: 1362.00-00, 1362.02-00,
                   1362.04-00                                      Person To Contact:
                                                                   -----------------------, ID No. -------------------
     ---------------------------------------                       ---------------------------------------------------
     -----------------------------------------------------------   Telephone Number:
     --------------------------                                    --------------------
     -----------------------------------                           Refer Reply To:
     ---------------------------------                             CC:PSI:B01
                                                                   PLR-113863-22
                                                                   Date:
                                                                   January 17, 2023




                                                        LEGEND


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

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

 IRA             =    -----------------------------------------------------------------------------
                      -----------------------

 State           =    -------------

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

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

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

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

 Year            =    -------

 $a              =    ---------------


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

  This letter responds to a letter dated July 14, 2022, and subsequent correspondence,
                                            2

submitted on behalf of X by X's authorized representatives, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code).

                                         FACTS

The information submitted states that X was organized under the laws of State on
Date 1 and elected to be treated as an S corporation, effective Date 1. As of Date 1,
IRA, an individual retirement account for the benefit of A and an ineligible shareholder,
held stock of X, thereby making X’s S election on Date 1 ineffective. Both A and X were
unaware that IRA was an ineligible shareholder. On Date 2, X learned that IRA was an
ineligible shareholder of X. On Date 3, IRA distributed its shares in X to A.

X represents that it has filed tax returns consistent with being an S corporation since
Date 1. The circumstances resulting in the termination of X’s S corporation
election were inadvertent and were not motivated by tax avoidance or retroactive tax
planning. X and its shareholders have agreed to make such adjustments (consistent
with the treatment of X as an S corporation) as may be required by the Secretary.

                                  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) defines an “S corporation” as a small business corporation for which
an election under § 1362(a) is in effect for the taxable year.

Section 1361(b)(1) provides that a “small business corporation” means a domestic
corporation that is not an ineligible corporation and that 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 1362(d)(2)(A) provides that an election under § 1362(a) shall be terminated
whenever (at any time on or after the first day of the first taxable year for which a
corporation is an S corporation) such corporation ceases to be a small business
corporation. Section 1362(d)(2)(B) provides that the termination shall be effective on
and after the date of cessation.

Section 1362(f) provides, in pertinent 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 section
1361(b), or 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 event resulting in the
ineffectiveness or termination, steps were taken (A) so that the corporation for which the
election was made or the termination occurred 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 such adjustments
(consistent with the treatment of the corporation as an S corporation) as may be
PLR-113863-22                                 3

required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in such ineffectiveness or termination, the corporation shall be
treated as an S corporation during the period specified by the Secretary.

                                      CONCLUSION

Based solely on the information submitted and the representations made, we conclude
that X’s S corporation election was ineffective on Date 1 because IRA was an ineligible
shareholder. We further conclude that this ineffectiveness of X’s S election was
inadvertent within the meaning of § 1362(f). Accordingly, pursuant to the provisions of
§ 1362(f), X will be treated as an S corporation from Date 1 and thereafter, provided X’s
S corporation election was valid and was not otherwise terminated under § 1362(d).

As a condition for this ruling, for open taxable years after Year that end prior to Date 3 in
which X reported a net loss, IRA will be treated as the shareholder of the shares of
stock. For the open tax periods beginning after Year that end prior to Date 3 in which X
reported a net gain, A will be treated as the shareholder of the shares of stock. All of X’s
shareholders in determining their respective income tax liabilities during the termination
period and thereafter must include their pro rata share of the separately stated items of
income (including tax exempt income), loss, deduction, or credit and non-separately
stated computed items of income or loss of X as provided in § 1366, make any
adjustments to basis provided in § 1367, and take into account any distributions made
by X as provided in § 1368. If X or its shareholders fail to treat X as described above,
this ruling will be null and void.

This letter ruling is also subject to the following condition: as an adjustment under
§ 1362(f)(4), X must send a payment of $a with a copy of this letter to the following
address:

  Internal Revenue Service
  Kansas City Service Center
  333 W. Pershing Road
  Kansas City, MO 64108
  Stop 7777
  Attn: Manual Deposit

X must send this payment no later than Date 4, 45 days from the date of this letter. If all
the above conditions are not met, then this ruling is null and void. Furthermore, if these
conditions are not met, X must notify the Kansas City Service Center that its S
corporation election has terminated.

Except as specifically ruled above, we express no opinion concerning the federal tax
consequences of the transactions described above under any other provision of the
Code. Specifically, no opinion is expressed on whether X is otherwise eligible to be
treated as an S corporation.
PLR-113863-22                                  4


This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the
Code 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 a power of attorney on file with this office, a copy of this letter is being
forwarded to X’s authorized representatives.



                                        Sincerely,



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

Enclosure

       Copy for § 6110 purposes



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