Inadvertent S-corporation termination relief after trusts missed their ESBT elections

Plain-English summary

An S corporation's tax status can be lost if the wrong kind of shareholder ends up
holding stock. Here, one of the company's shares was held by a trust that counted
as an eligible shareholder only because it was treated as owned by a living
individual. When that individual died, the trust could stay an eligible
shareholder for just two years. When that window closed, the trust needed to make
an "electing small business trust" (ESBT) election to keep the stock eligible, but
the trustee never filed it, so the company's S election ended. A later transfer of
shares to four more trusts would have ended the S election again for the same
missed-election reason. The company asked the IRS to treat the loss of S status as
inadvertent under Section 1362(f). The IRS agreed: the terminations were
inadvertent and not tax-motivated, and the company and shareholders had kept
filing as if the S election was still in place. So the company is treated as
continuing to be an S corporation, on the condition that the trustees file the
missing ESBT elections within 120 days.

Ruling snapshot

• Question: Was the loss of the company's S-corporation status inadvertent, so it can be treated as continuing to be an S corporation?
• Outcome: Approved (inadvertent termination relief under IRC § 1362(f), contingent on trustees filing ESBT elections within 120 days)
• Key authorities: IRC § 1362(f); § 1361(c)(2), (e); Treas. Reg. § 1.1361-1(m)(2)

Full text (IRS public release)

Internal Revenue Service                          Department of the Treasury
                                                  Washington, DC 20224

Number: 202426010                                 Third Party Communication: None
Release Date: 6/28/2024                           Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                  Person To Contact:
[Taxpayer name and address redacted]                --------------, ID No. --------
                                                  Telephone Number:
                                                    --------------
                                                  Refer Reply To:
                                                    CC:PSI:3
                                                  PLR-119646-23
                                                  Date:
                                                  April 01, 2024

Legend

X       = --------------
Trust 1 = --------------
Trust 2 = --------------
Trust 3 = --------------
Trust 4 = --------------
Trust 5 = --------------
Trust 6 = --------------
A       = --------------
State   = --------------
Date 1  = --------------
Date 2  = --------------
Date 3  = --------------
Date 4  = --------------

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

       This letter responds to a letter dated September 19, 2023, submitted on behalf of
X, requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                         FACTS

       According to the information submitted, X, a State corporation, elected to be an S
corporation effective Date 1. Trust 1 owned shares of stock in X. Trust 1 was treated
under subpart E of part I of subchapter J of chapter 1 as entirely owned by A, and, thus,
a permissible shareholder under § 1361(c)(2)(A)(i). On Date 2, A died and Trust 1
ceased to be a permissible shareholder under § 1361(c)(2)(A)(i). Under
§ 1361(c)(2)(A)(ii), Trust 1 remained an eligible shareholder for a 2-year period
beginning on the day of A's death. Following the expiration of the 2-year period on Date
3, Trust 1 continued to hold shares of X stock. X represents that Trust 1 qualified as an
electing small business trust (ESBT) within the meaning of § 1361(e), but the trustee of
Trust 1 failed to make an ESBT election under § 1361(e)(3) for Trust 1 effective Date 3.
Thus, Trust 1 became an ineligible shareholder of X on Date 3 which caused X's S
corporation election to terminate on Date 3.

       On Date 4, Trust 1 transferred its shares of X stock to Trust 3 and Trust 4, and
Trust 2, a shareholder of X, transferred its shares of X stock to Trust 5 and Trust 6. X
represents that Trust 3, Trust 4, Trust 5, and Trust 6 (collectively, the Trusts) qualified
as ESBTs within the meaning of § 1361(e), but the trustees of the Trusts failed to make
ESBT elections under § 1361(e)(3) for the Trusts effective Date 4. Therefore, had X's S
corporation election not terminated on Date 3, it would have terminated on Date 4 when
shares of X stock were transferred to ineligible shareholders.

         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. X also represents that (1) X and its shareholders have filed
their tax returns consistent with X being an S corporation since Date 1, (2) Trust 1 has
filed its income tax returns consistent with being an ESBT effective Date 3, and (3) the
Trusts have filed their income tax returns consistent with being ESBTs effective Date 4.
Finally, X and its shareholders have agreed 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)(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) 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)(ii) provides that for purposes of § 1361(b)(1)(B), a trust
which was described in § 1361(c)(2)(A)(i) immediately before the death of the deemed
owner and which continues in existence after such death may be an S corporation
shareholder, but only for the 2-year period beginning on the day of the deemed owner's
death.

      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) 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(m)(2)(i) of the Income Tax Regulations provides, in relevant
part, that the trustee of an ESBT must make the ESBT election by signing and filing,
with the service center where the S corporation files its income tax return, a statement
that meets the requirements of § 1.1361-2(m)(2)(ii).

      Section 1362(a) provides that a small business corporation may elect to be an S
corporation.

       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) shall be 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); (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 such
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 in the corporation at any time during
the period specified pursuant to § 1362(f), agrees to make the adjustments (consistent
with the treatment of the corporation as an S corporation) as may be required by the
Secretary with respect to such 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.

                                    CONCLUSION

        Based solely on the facts submitted and representations made, we conclude that
X's S corporation election terminated on Date 3 when Trust 1 became an ineligible
shareholder under § 1361(b)(1)(B). In addition, had X's S corporation election not
terminated on Date 3, we conclude that it would have terminated on Date 4 when the
trustees of the Trusts failed to file ESBT elections for the Trusts effective Date 4. We
further conclude that the circumstances resulting in the termination of X's S corporation
election were inadvertent within the meaning of § 1362(f). Therefore, under § 1362(f), X
will be treated as continuing to be an S corporation from Date 3 and thereafter, provided
that X's S corporation election was valid and has not otherwise terminated under
§ 1362(d) for reasons not addressed in this letter.

       This ruling is contingent on the trustees of the Trusts filing within 120 days from
the date of this letter ESBT elections effective Date 4 for the Trusts with the appropriate
service center. A copy of this letter should be attached to each ESBT election.

       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 and the regulations thereunder. Specifically, we express or imply
no opinion regarding X's eligibility to be an S corporation or Trust 1's and the Trusts'
eligibility to be ESBTs.

       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 requested ruling, it is subject to verification on examination.

       This ruling is directed only to the taxpayer that requested 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
                                       Mary Beth Carchia
                                       Senior Technician Reviewer, Branch 3
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)


Enclosure:
      Copy of this letter for § 6110 purposes

cc: