Inadvertent S corporation termination excused after ownership change

Plain-English summary

An S corporation's shares were held through a disregarded limited liability company owned by two grantor trusts. When the grantor died, the limited liability company became a partnership and therefore an ineligible S corporation shareholder, terminating the S election. One trust then acquired the other trust's interest so the limited liability company again became disregarded, and both trusts made electing small business trust elections for the relevant periods. The IRS found the termination inadvertent and allowed the company to continue being treated as an S corporation for the period specified in the ruling. The relief requires both trusts to file any original or amended returns needed to reflect their ESBT treatment within 120 days.

Ruling snapshot

• Question: May the company retain S corporation treatment after a disregarded entity temporarily became a partnership and an ineligible shareholder?
• Outcome: Approved as an inadvertent termination, subject to trust return filings
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service                                  Department of the Treasury
                                                          Washington, DC 20224

Number: 202347005                                         Third Party Communication: None
Release Date: 11/24/2023                                  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:B03
                                                          PLR-104299-23
                                                          Date:
                                                          August 28, 2023




Legend:

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

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

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

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

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

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

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

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

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

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

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

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

Trust 2      = ----------------------------------
               ------------------------
PLR-104299-23                                 2



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

        This letter responds to a letter dated February 22, 2023, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                          FACTS

        According to the information submitted, X was formed under the laws of State on
Date 1 and elected to be an S corporation effective Date 2. Effective Date 2, Trust 1, an
eligible S corporation shareholder under § 1361(c)(2)(A)(i), owned shares of X directly
and through Y, a State limited liability company that was disregarded as an entity
separate from its owner for federal tax purposes. A, an individual, was the deemed
owner of Trust 1 under § 1361(c)(2)(B)(i).

        On Date 3, Trust 1 sold an interest in Y to Trust 2, a grantor trust of A. Following
the sale, Y continued to be disregarded as an entity separate from its owner, A, for
federal tax purposes. On Date 4, A died thereby causing Y to be classified as a
partnership for federal tax purposes and an ineligible S corporation shareholder under
§ 1361(b)(1)(B). Thus, X’s S corporation election terminated on Date 4. Before X
learned that its S corporation election had terminated, the trustee of Trust 1 made an
election to treat Trust 1 as an electing small business trust (ESBT) under § 1361(e)(3)
effective Date 4.

       On Date 5 shortly after X learned that its S corporation election had terminated
on Date 4, Trust 2 purchased the remaining interest in Y from Trust 1 causing Y to be
disregarded as an entity separate from its owner for federal tax purposes.
Subsequently, the trustee of Trust 2 made an election to treat Trust 2 as an ESBT under
§ 1361(e)(3) effective Date 5. Effective Date 6, X made an election to be classified as a
partnership for federal tax purposes.

       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, X represents that prior to Date 6, it has always filed its
tax returns consistent with the treatment of X as an S corporation. 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 the year.
PLR-104299-23                                 3


       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 of the Code)
as owned by an individual who is a citizen or resident of the United States may be an S
corporation shareholder.

      Section 1361(c)(2)(A)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT
may be an S corporation shareholder.

       Section 1361(e)(1)(A) defines an ESBT as 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 a 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 all subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

       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(d)(2)(B) provides that any termination under
§ 1362(d)(2) is effective on and after the date of cessation.

        Section 1362(f) provides, in relevant 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 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
PLR-104299-23                                 4

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 4 when Y became an ineligible
shareholder. We also conclude that the circumstances resulting in the termination of
X’s S corporation election were inadvertent within the meaning of § 1362(f). Therefore,
pursuant to the provisions of § 1362(f), X will continue to be treated as an S corporation
from Date 4 through Date 7, provided that X’s S corporation election was valid and has
not otherwise terminated under § 1362(d).

       This ruling is contingent on Trust 1 and Trust 2 filing returns, including amended
returns, with the appropriate service center within 120 days from the date of this letter to
properly reflect the treatment of Trust 1 and Trust 2 as ESBTs effective Date 4 and Date
5, respectively. A copy of this letter should be attached to the returns.

         Except as expressly provided herein, we express or imply no opinion concerning
the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter. Specifically, we express or imply no opinion regarding X’s eligibility to be
an S corporation, or Trust 1’s or Trust 2’s eligibility to be an ESBT.

       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.

      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.

      In accordance with a power of attorney on file with this office, we are sending a
copy of this letter to X's authorized representatives.


                                       Sincerely,

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


Enclosure:
      Copy of this letter for § 6110 purposes
PLR-104299-23                                           5


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