Inadvertent S-corporation termination relief after trust beneficiaries missed their QSST elections

Plain-English summary

An S corporation can lose its tax status if the wrong kind of shareholder holds
its stock. A trust can hold S-corporation stock only if it fits an allowed
category, and one common route is for the beneficiary to make a "qualified
subchapter S trust" (QSST) election. Here, a shareholder moved company stock into
a trust that was split into two equal separate trusts for two beneficiaries. Each
separate trust could have qualified as a QSST, but the beneficiaries never filed
the QSST elections, so the company's S election terminated on that date. The
company asked the IRS to treat the loss of S status as inadvertent under Section
1362(f). The IRS agreed: the termination was inadvertent and not tax-motivated,
and the company kept filing as an S corporation throughout. So the company is
treated as continuing to be an S corporation, on the condition that the
beneficiaries file the missing QSST elections and file amended returns within 120
days. If those conditions are not met, the ruling is void.

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 QSST elections and amended returns within 120 days)
• Key authorities: IRC § 1362(f); § 1361(b), (c)(2), (d); Treas. Reg. § 1.1361-1(j)

Full text (IRS public release)

Internal Revenue Service                          Department of the Treasury
                                                  Washington, DC 20224

Number: 202427002                                 Third Party Communication: None
Release Date: 7/5/2024                             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:B03
                                                  PLR-119811-23
                                                  Date:
                                                  April 5, 2024

Legend:

X       = --------------
Y       = --------------
A       = --------------
B       = --------------
C       = --------------
State 1 = --------------
State 2 = --------------
Trust 1 = --------------
Trust 2 = --------------
Date 1  = --------------
Date 2  = --------------
Date 3  = --------------
Date 4  = --------------
Date 5  = --------------

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

        This letter responds to a letter dated September 21, 2023, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code (the Code).

                                         FACTS

       According to the information submitted and representations within, prior to
formation of X, Y was formed on Date 1, under the laws of State 1. Effective Date 2, Y
elected to be treated as an S corporation. X was incorporated on Date 3 under the laws
of State 2. Y merged into X pursuant to a reorganization and was treated as
succeeding Y's election to be an S corporation.

       A, then a principal shareholder of Y and current shareholder of X, established
Trust 1 and Trust 2 on Date 4. Trust 2 had two beneficiaries, B and C. Trust 2 was
divided into two equal separate and independent trusts for the beneficiaries.

       A initially funded Trust 1 with shares of Y. On Date 5, the shares that A
previously transferred to Trust 1 was transferred to Trust 2. X represents that each of
the separate trusts under Trust 2 were eligible to make a Qualified Subchapter S Trust
(QSST) election under § 1361(d)(3) as of Date 5. Each Trust 2 share was treated as a
separate share under § 663(c). However, B and C failed to timely make the QSST
election effective Date 5 causing X's S corporation election to terminate on Date 5.

        X represents that both trusts under Trust 2 has met all the requirements for
qualifying as a QSST under § 1361(d)(3), other than filing of a timely QSST election
under §1361(d)(2).

       X further represents that the circumstances resulting in the termination of X's S
election were inadvertent and were not motivated by tax avoidance or retroactive tax
planning. Additionally, X represents that X and its shareholders have filed all returns
consistent with X's status as an S Corporation. 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) 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 the term "small business corporation" means 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 1 of subchapter J of chapter 1) as owned by
an individual who is a citizen or resident of the United States is a permitted S
corporation shareholder.

        Section 1361(d)(1) provides that, in the case of a QSST with respect to which a
beneficiary makes an election under § 1361(d)(2), such trust shall be treated as a trust
described in § 1361(c)(2)(A)(i) and for purposes of § 678(a), the beneficiary of such
trust shall be treated as the owner of that portion of the trust which consists of stock in
the S corporation with respect to which the election under § 1361(d)(2) is made.

         Section 1361(d)(3) defines a QSST as a trust (A) the terms of which require that
(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust; (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary; (iii) the income interest of the
current income beneficiary in the trust shall terminate on the earlier of the beneficiary's
death or the termination of the trust; and (iv) upon the termination of the trust during the
life of the current income beneficiary, the trust shall distribute all of its assets to that
beneficiary, and (B) all of the income (within the meaning of § 643(b)) of which is
distributed (or required to be distributed) currently to one individual who is a citizen or
resident of the United States. A substantially separate and independent share of a trust
within the meaning of § 663 shall be treated as a separate trust for purposes of this
§ 1361(d)(3) and § 1361(c).

       Section 1.1361-1(j)(7)(i) of the Income Tax Regulation provides that the income
beneficiary who makes the QSST election and is treated (for purposes of § 678(a)) as
the owner of that portion of the trust that consists of S corporation stock is treated as the
shareholder for purposes of §§ 1361(b)(1), 1366, 1367, and 1368.

       Section 1.1361-1(j)(6)(iii) provides that the QSST election must be filed within the
time requirements of § 1.1361-1(j)(6)(ii)(A) through (E).

       Section 1362(a) of the Code 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 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 under § 1362(d)(2)(A)
shall be effective on and after the date of cessation.

        Section 1362(f) provides relevant part, that if (1) an election under § 1362(a) by
any corporation (A) 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 to obtain shareholder consents, or (B) 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 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 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 facts submitted and representations made, we conclude that
X's S corporation election terminated on Date 5 because beneficiaries of separate
shares of Trust 2 failed to file a timely QSST election under § 1361(d)(2).

      We further conclude that the termination of X's S election on Date 5 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 Date 1, and thereafter, provided X's S
corporation election was otherwise valid and not otherwise terminated under § 1362(d).

        This ruling is contingent on the beneficiaries of separate shares of Trust 2 filing a
QSST election for each respective shares of Trust 2 effective Date 5, with the
appropriate service center within 120 days from the date of this letter. A copy of this
letter should be attached to the QSST elections. In addition, each of the separate trusts
under Trust 2 must file within 120 days from the date of this letter amended returns for
all years consistent with the requested relief to properly reflect the treatment of each
separate shares of Trust 2 as a QSST and attach a copy of this letter to such returns.

        If the above conditions are not met, then this ruling is null and void. Furthermore,
if these conditions are not met, X must notify the service center with which it filed its
S corporation election that its election terminated on Date 5.

         Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the facts described above under any other provisions
of the Code and the regulations thereunder, including whether X was otherwise a valid
S corporation and whether each separate shares of Trust 2 are a valid QSST within the
meaning of § 1361(d)(3). Specifically, we express or imply no opinion concerning Y's
eligibility to be an S corporation. Further we express or imply no opinion concerning the
validity or tax consequences of the merger of Y and X.

      The rulings contained in this letter are 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.

      These rulings are directed only to the taxpayer requesting them.
Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

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

                                              Sincerely,




                                              Richard T. Probst
                                              Senior Technician Reviewer, Branch 3
                                              Office of Associate Chief Counsel
                                              (Passthroughs & Special Industries)




Enclosure:
      Copy of this letter for § 6110 purposes

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