PLR 200031002: Relief for S election invalidated by an ineligible shareholder

Plain-English summary

A corporation intended to elect S status, but a partnership still held its shares for part of the period before transferring them to a trust. That ineligible shareholder made the corporation's election ineffective as of its intended start date. The IRS granted relief under section 1362(f), treating the corporation as an S corporation from that date if its election was otherwise valid, no later termination occurred, and the trust and other parties reported consistently with the ruling. For the period when the partnership held the shares, the trust had to report the corporation's items and distributions as if it had owned them. The IRS expressly did not determine whether the corporation otherwise qualified as an S corporation.

Ruling snapshot

• Question: Could the corporation receive relief for an S election made while a partnership was an ineligible shareholder?
• Outcome: Approved, subject to the stated eligibility and reporting conditions.
• Key authorities: IRC §§ 1361, 1362(f), 1367, and 1368.

Full text (IRS public release)

Internal Revenue Service       Department of the Treasury

Index Number:     1361.03-02   Washington, DC 20224



Number: 200031002              Person to Contact:
Release Date: 8/4/2000         Telephone Number:

                               Refer Reply To:
                               CC:DOM:P&SI:Br.1-PLR-119136-99
                               Date:
                                  April 28, 2000




Legend

X                 =


TRUST             =


PRS               =


A                 =

D1                =

D2                =

D3                =

D4                =

D5                =

STATE             =
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    PLR-119136-99



        This responds to your representative’s letter dated November 22, 1999, and
subsequent correspondence, submitted on behalf of X requesting relief under § 1362(f)
of the Internal Revenue Code for an invalid subchapter S election.

                                         FACTS

       X incorporated under STATE law on D1 and decided to elect subchapter S
status as of D2. While completing the Form 2553, X determined that it had an ineligible
shareholder, PRS. On D3, therefore, PRS transferred the X shares that it held to
TRUST, which X represents was a qualified subchapter S shareholder under
§ 1361(c)(2). X’s shareholders then filed Form 2553 on D4, electing subchapter S
status for X as of D2. Unknown to X, it’s subchapter S election was invalid because X
had an ineligible shareholder during the period D2 to D3.

      On D5, A purchased the majority of X’s stock. During A’s due diligence of X’s
records, A discovered that X had an ineligible shareholder during the period D2 to D3,
making its subchapter S election invalid.

                                  LAW AND ANALYSIS

        Section 1361(a)(1) provides that an “S corporation” is, with respect to a given
year, a small business corporation for which an election under § 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 § 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 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 a shareholder.

        Section 1362(f) provides, in part, that, if (1) an election under § 1362(a) by any
corporation was not effective because of the failure of the corporation to meet the
requirements of § 1361(b), (2) the Secretary determines that the circumstances
resulting in the ineffective election were inadvertent, (3) no later than a reasonable
period of time after discovery of the circumstances resulting in the ineffectiveness,
steps were taken so that the corporation 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 a subchapter S corporation) as may
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    PLR-119136-99

be required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in the termination, the corporation will be treated as a
subchapter S corporation during the period specified by the Secretary.

                                     CONCLUSION

       Based upon the information submitted and representations made, we conclude
that X’s subchapter S status was ineffectively elected as of D2. Therefore, under
§ 1362(f), X will be treated as an S corporation from D2 and thereafter provided: 1)
notwithstanding the ineligible shareholder, X was otherwise eligible to be an S
corporation on D2, and its election was timely and validly filed; 2) X’s election was not
otherwise terminated under § 1362(d), and, 3) during the period D2 to D3, TRUST will
be treated as if it owned X’s stock instead of PRS. Accordingly, pursuant to
§ 1361(d)(1), TRUST, in determining its income tax liabilities during the period from D2
to D3 when PRS owned the X shares, must include the pro rata share of the separately
and nonseparately computed items of X as provided in § 1367, and take into account
any distributions made by X as provided by § 1368. If X, PRS, TRUST, or any of X's
other shareholders fail to treat X as described above, this ruling shall be void.

       Except as specifically set forth above, no opinion is expressed concerning the
federal tax consequences of the facts described above under any other provision of the
Code. Specifically, no opinion is expressed concerning whether X is a subchapter S
corporation for federal tax purposes.

        Pursuant to a power of attorney on file with our office, we are sending a copy of
this letter to X. This ruling is directed only to the taxpayers who requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.

                                                   Sincerely,

                                                   Signed/Dianna K. Miosi
                                                   Dianna K. Miosi
                                                   Chief, Branch 1
                                                   Office of the Assistant Chief Counsel
                                                   (Passthroughs and Special Industries)


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