IRS forgives an inadvertent S corporation termination after a conversion put shares in an ineligible partnership

Plain-English summary

A company was formed as a corporation and elected S corporation status. Later it
converted from a state corporation into a state limited partnership and elected
(on Form 8832) to still be taxed as a corporation, treating the change as an
"F reorganization" so it could keep its S status. Two problems arose. First,
shares ended up held by a partnership, and a partnership is not an eligible S
corporation shareholder. Second, converting into a limited partnership may have
created a prohibited second class of stock. Either issue would terminate the S
election. Once the company caught the mistakes, it fixed them: the partnership
shareholder converted into a disregarded entity, and the company itself became
an LLC. The company said the termination was inadvertent and not tax-motivated,
and everyone had filed as if it were still an S corporation. The IRS granted
relief under Code section 1362(f), treating the company as continuing to be an S
corporation from the conversion date, as long as it and its shareholders file
original and amended returns consistent with that treatment. (This ruling,
PLR-117294-22, is a companion to the nearly identical PLR 202322010.)

Ruling snapshot

• Question: Was the termination of the company's S corporation status
  (ineligible partnership shareholder, and a possible second class of stock
  after conversion) inadvertent and eligible for relief under IRC § 1362(f)?
• Outcome: Approved. Treated as an S corporation from the conversion date,
  contingent on filing consistent original and amended returns.
• Key authorities: IRC §§ 1362(f), 1362(d)(2), 1361(b)(1);
  § 368(a)(1)(F) (F reorganization).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202322009 Third Party Communication: None
Release Date: 6/2/2023 Date of Communication: Not Applicable

Index Number: 1362.00-00, 1362-01.00, Person To Contact:
1362.02-00, 1362.02-02, --------------------------, ID No. ----------------
1362-04.00 Telephone Number:
--------------------
------------------------------------------- Refer Reply To:
------------------------------- CC:PSI:B01
-------------------------- PLR-117294-22
-------------------------- Date:
------------------------------ March 9, 2023

LEGEND
X = ----------------------------------------------------------------------
-----------------------

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

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

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

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

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

State = --------

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

This responds to a letter dated September 7, 2022, submitted on behalf of X by its
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code (the Code).

FACTS

According to the information submitted and representations within, X was formed under
the laws of State on Date 1 as a corporation. X elected to be treated as an S
corporation effective Date 1. 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. On Date 2, shares in X were transferred to A, a
partnership.

A, as a partnership, was an ineligible shareholder of an S corporation. Additionally, 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. On Date 3, the shareholders
of X took remedial action by having A convert to an entity disregarded as separate from
its owner. Additionally, X has converted to a limited liability company effective Date 4.

X represents that the termination of its S corporation status was inadvertent and was
not motivated by tax avoidance or retroactive tax planning. X represents that all
shareholders filed their returns consistent with X being an S corporation. Further, X
represents that X and its shareholders agree to make any adjustments required as a
condition of obtaining relief for the termination of X's election as provided under
§ 1362(f) of the Code that may be required by the Secretary.

LAW AND ANALYSIS

Section 1361(a)(1) of the Code 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 1362(d)(2)(A) provides that an election under § 1362(a) shall be terminated
whenever the 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 the representations made, 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 X's S corporation
status terminated within the meaning of § 1362(f) on Date 2 because A was an ineligible
shareholder. Pursuant to the provisions of § 1362(f), X will be treated as an S
corporation from Date 2 and thereafter, provided X's S corporation election is otherwise
effective and not terminated under § 1362(d).

This letter ruling is contingent upon X and its shareholders filing any original and
amended returns for all open taxable years consistent with the relief granted in this
letter. If this condition is not met, then this 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.

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 representatives.

                                  Sincerely,


                                                           /s/

                                  Joy C. Spies
                                  Senior Technician Reviewer, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosure
Copy for § 6110 purposes

cc: