S corporation's inadvertent termination forgiven where a trust shareholder missed its ESBT election

Plain-English summary

A company taxed as an S corporation had a shareholder that was a trust. The trust started out as a grantor trust (treated as owned by an individual, which is an eligible S corporation shareholder), but when it stopped being a grantor trust it needed to make a timely "electing small business trust" (ESBT) election under section 1361(e)(3) to remain an eligible shareholder. The trustees missed that election, which made the trust an ineligible shareholder and automatically terminated the company's S corporation status. Under section 1362(f), the IRS can forgive an inadvertent termination if the lapse was not tax-motivated, everyone acted consistently with the S election, and any required adjustments are agreed to. The IRS found the termination inadvertent and ruled the company will be treated as continuing to be an S corporation, on the condition that the trustees file the ESBT election (effective the date the trust stopped being a grantor trust) within 120 days. The IRS expressed no opinion on whether the company or the trust otherwise qualified.

Ruling snapshot

• Question: Was the termination of the company's S corporation election, caused by a trust shareholder's missed ESBT election, inadvertent and eligible for relief under section 1362(f)?
• Outcome: Approved (inadvertent-termination relief granted, conditioned on filing the ESBT election within 120 days)
• Key authorities: IRC § 1362(f); § 1361(b)(1); § 1361(c)(2); § 1361(e); § 1362(d)(2); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

Internal Revenue Service                                    Department of the Treasury
                                                            Washington, DC 20224

Number: 202319008                                           Third Party Communication: None
Release Date: 5/12/2023                                     Date of Communication: Not Applicable
Index Number: 1361.03-03, 1362.00-00,
              1362.04-00                                    Person To Contact:
                                                            --------------------------, ID No. ----------------
-----------------------------------------------             -----------------
-------------------------------------------------           Telephone Number:
-------------------------                                   --------------------
---------------------------                                 Refer Reply To:
                                                            CC:PSI:B01
------------------------------------                        PLR-116113-22
                                                            Date:
                                                            February 10, 2023




                                                     LEGEND

  X            = -------------------------------------------------
                 TIN: ----------------

  A            = ---------------------------------
                 TIN: -----------------

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

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

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

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

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


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

      This responds to a letter dated August 19, 2022, and additional 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 formed on Date 1 under the laws of
State and elected to be treated as an S corporation effective Date 2. Trust was formed
on Date 3 and was treated as a wholly-owned grantor trust under §§ 671 and 676 as to
A. Trust first acquired shares in X on Date 3.

       On Date 4, Trust ceased to be a wholly-owned grantor trust as to A. X represents
that Trust qualified to elect to be treated as an Electing Small Business Trust (ESBT) as
of Date 4. However, the trustees of Trust failed to make a timely ESBT election under §
1361(e)(3), thereby causing X’s S corporation election to terminate on Date 4.

       X represents that the circumstances resulting in the failure to file an ESBT election
for Trust were inadvertent and not motivated by tax avoidance or retroactive tax planning.
X also represents that it has filed income tax returns consistent with having a valid S
election in effect for all taxable years since its election to be an S corporation, and that
Trust has filed income tax returns consistent with having an ESBT election in effect for all
relevant years. X further represents that X and its shareholders agree to make any
adjustments required by the Secretary as a condition of obtaining relief under the
inadvertent termination rule as provided under § 1362(f).

                                  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 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 I of subchapter J of Chapter 1 of the Code)
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)(v) provides that, for purposes of § 1361(b)(1)(B), an electing
small business trust (ESBT) may be an S corporation shareholder.

       Section 1361(e)(1)(A) provides that an ESBT 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), (3), (4), or (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)(1)(B) provides that the term “electing small business trust” shall
not include (i) any qualified subchapter S trust (as defined in § 1361(d)(3)) if an election
under § 1361(d)(2) applies to any corporation the stock of which is held by such trust,
(ii) any trust exempt from tax under subtitle A, and (iii) any charitable remainder annuity
trust or charitable remainder unitrust (as defined in § 664(d)).

       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
all subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

       Section 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the ESBT
election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a QSST
election (generally within the 16-day-and-2-month period beginning on the day that the
stock is transferred to the trust).

      Section 1362(d)(2) provides that an S corporation election 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 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.

                                      CONCLUSION

       Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election terminated on Date 4 when the trustees of Trust failed to file
an ESBT election under § 1361(e)(3). We further conclude that the termination of X’s S
corporation election was inadvertent within the meaning of § 1362(f). Therefore, under §
1362(f), X will be treated as continuing to be an S corporation on and after Date 4,
provided X’s S corporation election was otherwise valid and not otherwise terminated
under § 1362(d).

        This letter ruling is subject to the condition that within 120 days from the date of
this letter, the trustees of Trust must file an ESBT election with respect to Trust effective
Date 4 with the appropriate service center. A copy of this letter should be attached to the
ESBT election. If this condition is not met, then this letter ruling is null and void.

       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 an ESBT.

      This ruling is directed only to the taxpayer who requested it. According to §
6110(k)(3), 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 the power of attorney on file with this office, we are sending a copy of
this letter to your authorized representative.

                                          Sincerely,


                                          _/s/_____________________________
                                          Laura C. Fields
                                          Branch Chief, Branch 1
                                          Office of the Associate Chief Counsel
                                          (Passthroughs & Special Industries)


Enclosures
      Copy of this letter for Section 6110 purposes


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