PLR 200011030: Corporate shareholder after merger caused an inadvertent S election termination

Plain-English summary

An S corporation merged with another corporation and acquired a C corporation as a shareholder. That shareholder was ineligible to own S corporation stock, so the S election terminated on the merger date. After discovering the problem, the C corporation distributed its shares to its sole shareholder, an eligible individual. The IRS found the termination inadvertent and said the corporation would be treated as continuing to be an S corporation from the merger date, provided its election did not otherwise terminate. The letter did not decide whether the original S election had been valid.

Ruling snapshot

• Question: Could the corporation retain S status despite the temporary ineligible shareholder?
• Outcome: Approved: the termination was inadvertent, with continuing S treatment under section 1362(f).
• Key authorities: IRC §§ 1362(f), 1362(d)(2), and 1361(b)(1).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Index Number: 1362.04-00 Washington, DC 20224

Number: 200011030
Person to Contact:
Release Date: 3/17/2000
Telephone Number:

Refer Reply To:
CC:DOM:P&SI:1-PLR-116675-99
Date:
December 17, 1999

Legend

X =
Y =
Z =
Date 1 =
Date 2 =
Date 3 =
Date 4 =
State =
A =

This responds to your letter dated October 11, 1999, submitted on behalf of X, requesting a ruling under section 1362(f) of the Internal Revenue Code.

Facts

The information submitted discloses that X is a corporation organized under the laws of State on Date 1. On Date 2, X elected to be treated as an S corporation. Y is also a corporation organized under the laws of State.

X and Y executed an Agreement of Merger (the Agreement) effective Date 3.
Under the terms of the Agreement, X and Y were to merge pursuant to State law and section 368(a)(1)(A). At the time of the merger all of the shareholders of X and 99% of the shareholders of Y were owned by individuals who were eligible shareholders within the meaning of 1361(b)(1)(B); however, 1% of Y was owned by Z, a C corporation. Because a C corporation is not an eligible shareholder of an S corporation, X’s subchapter S election terminated Date 3.

When X discovered that Z, an ineligible shareholder, held .012% of its outstanding stock, Z distributed all of its X stock to its sole shareholder A, an individual eligible to own S corporation stock, on Date 4.

X represents that, during the termination period, it has timely and consistently filed its tax returns consistent with its treatment as an S corporation. X further

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represents that the termination of its S election was not motivated by tax avoidance.

X and each person who was a shareholder of X during the termination period agree to make the adjustments (consistent with X’s treatment as an S corporation) that are required by the Secretary with respect to the termination period. Further, X represents that A, Z’s sole shareholder, shall report Z’s pro rata share of X’s items of income, loss, deduction and credit from Date 3 to Date 4.

Law and Analysis

Section 1361(a)(1) defines an S corporation as a small business corporation for which an election under section 1362(a) is in effect. Section 1361(b)(1) defines "small business corporation" as a domestic corporation that is not an ineligible corporation and that does not (A) have more than 75 shareholders, (B) have as a shareholder a person (other than an estate, other than a trust described in section 1361(c)(2), and other than an organization described in (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 1362(d)(2)(A) of the Code provides that an election to be treated as an S corporation terminates whenever (at any time on or after the first day of the first taxable year for which the corporation is an S corporation) the corporation ceases to be a small business corporation. The termination is effective on and after the date the S corporation ceases to meet the requirements of a small business corporation. Section 1362(d)(2)(B).

Section 1362(f) of the Code provides that if (1) an election to be treated as an S corporation was terminated under section 1362(d) (2) or (3), (2) the Secretary determines that the termination was inadvertent, (3) no later than a reasonable period of time after discovery of the event resulting in such termination, steps were taken so that the corporation is once more 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 this subsection, 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 that period, then, notwithstanding the terminating event, the corporation shall be treated as continuing to be an S corporation during the period specified by the Secretary.

S. Rep. No. 640, 97th Cong., 2d Sess. 12-13 (1982), 1982-2 C.B. 718, 723-24, in discussing section 1362(f) of the Code, provides, in part, as follows:

If the Internal Revenue Service determines that a corporation's subchapter S election is inadvertently terminated, the Service can waive the effect of the terminating event for any period if the corporation timely corrects the event and if the corporation and the shareholders agree to be

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treated as if the election had been in effect for such period.

The committee intends that the Internal Revenue Service be reasonable in granting waivers, so that corporations whose subchapter S eligibility requirements have been inadvertently violated do not suffer the tax consequences of a termination if no tax avoidance would result from the continued subchapter S treatment. In granting a waiver, it is hoped that taxpayers and the government will work out agreements that protect the revenues without undue hardship to taxpayers . . . It is expected that the waiver may be made retroactive for all years, or retroactive for the period in which the corporation again became eligible for subchapter S treatment, depending on the facts.

Conclusions

Based upon the information submitted and the representations set forth above, we conclude that the termination of X’s S corporation election was inadvertent within the meaning of section 1362(f) .

Pursuant to the provisions of section 1362(f), X will be treated as continuing to be an S corporation from Date 3 and thereafter, provided that X’s subchapter S election is not otherwise terminated under section 1362(d).

Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the above-described facts under any other provision of the Code. In particular, no opinion is expressed or implied concerning whether X’s S election was valid under section 1362.

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.

Pursuant to a power of attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,
David R. Haglund
Senior Technician Reviewer, Branch 1
Office of the Assistant Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes