PLR 200007024: Inadvertent S corporation termination after an ineligible shareholder joined

Plain-English summary

An S corporation admitted an ineligible shareholder, which terminated its S election. Its president did not know the admission would have that effect, and the accountant later discovered the issue while preparing a return. Eligible shareholders then acquired the ineligible shareholder's stock. The IRS found the termination inadvertent under section 1362(f) and treated the corporation as an S corporation during the affected period and thereafter, assuming its election was otherwise valid. All shareholders, including the ineligible shareholder, had to report their shares of the corporation's items and make the required basis and distribution adjustments; failure to do so would void the ruling.

Ruling snapshot

• Question: Could the corporation retain S status after inadvertently admitting an ineligible shareholder?
• Outcome: Approved: inadvertent termination relief, conditioned on consistent tax treatment by the corporation and shareholders
• Key authorities: IRC §§ 1361, 1362(d) and (f), 1366, 1367, and 1368

Full text (IRS public release)

INTERNAL REVENUE SERVICE
Index No: 1362.04-00
Number: 200007024
Release Date: 2/18/2000

CC:DOM:P&SI:2 - PLR-112561-99
Nov. 19, 1999
X
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Y
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A
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B
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C
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D
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E
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F
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G
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H
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Date 1
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Date 2
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Date 3
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Date 4
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Date 5
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Dear

This is in reply to your letter dated June 30, 1999, submitted on behalf of X requesting a ruling under § 1362(f) of the Internal Revenue Code.

X was incorporated on Date 1. X elected to be an S corporation effective Date 2. The shareholders of X are A, B, C, D, E, F, G, and H. On Date 3, Y an ineligible shareholder was admitted as a shareholder. The admission of Y as a shareholder resulted in the termination of X's S corporation election.

• 2 -

A, X’s president was unaware that the admission of Y as a shareholder would cause X’s S corporation election to terminate.

In Date 4, you, as the accountant for X, discovered during the preparation of X’s tax return, the ownership of X’s stock by Y. On Date 5, the X stock owned by Y was acquired by 3 eligible shareholders.

A represents that the terminating event was not part of a plan to terminate X’s S election or for tax avoidance purposes . X and its shareholders have agreed to make any adjustments that the Commissioner may require, consistent with the treatment of X as an S corporation.

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) of the Code provides, in part, that the term "small business corporation" means a domestic corporation which is not an ineligible corporation.

Section 1362(d)(2)(A) of the Code provides that an election under § 1362(a) shall be terminated whenever (at any time on or after the 1st day of the 1st taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(f) of the Code provides 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 paragraph (2) or (3) of § 1362(d), (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 (A) so that the corporation is a small business corporation, or (B) to acquire the required shareholder consents, and (4) the corporation, and each person who was a shareholder in 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.

• 3 -

Based solely on the facts submitted and the representations made, we hold that X’s election to be an S corporation terminated on Date 3, as a result of the acquisition by Y of the stock of X. We also hold that the termination was inadvertent within the meaning of § 1362(f) of the Code.

We further hold that, pursuant to the provisions of § 1362(f) of the Code, X will be treated as an S corporation from Date 3 to Date 5, and thereafter, provided that X's election to be an S corporation was otherwise valid and was not terminated under § 1362(d). Therefore, the shareholders of X, including Y, must include their pro rata share of the separately stated and nonseparately computed items of X as provided in § 1366, make any adjustments to basis as provided in § 1367, and take into account any distributions made by X as provided in § 1368. If X or its shareholders fail to treat X as described above, this letter ruling will be null and void.

Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provisions of the Code.

This ruling is directed only to the taxpayer who requested it. 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, a copy of this letter is being sent to X.

Sincerely yours,

J. THOMAS HINES
Acting Branch Chief, Branch 2
Office of the Assistant
Chief Counsel
(Passthroughs and
Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes