PLR 200050018: Ineligible corporate shareholders do not end S status after corrective redemptions

Plain-English summary

An S corporation issued shares to three other corporations, which were ineligible S corporation shareholders. After discovering the problem, it promptly arranged to redeem their shares at the original purchase prices. The IRS found that the S election had terminated when the first ineligible corporation acquired stock, but that the termination was inadvertent. It allowed the company to be treated as continuing as an S corporation if the income, deductions, and credits that would have gone to the three corporate shareholders were instead allocated among the other shareholders as if those corporations had never held stock. This relief also depended on the S election not ending for another reason.

Ruling snapshot

• Question: Can the company retain S treatment after issuing stock to ineligible corporate shareholders?
• Outcome: Yes, with the specified reallocations and provided the election did not otherwise terminate.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(d)(2), 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200050018
Washington, DC 20224
Release Date: 12/15/2000
Index Number: 1362.04-00
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:1-PLR-116274-00
Date:
September 13, 2000

Legend:

X =
A =
B =
C =
a = b = c =

State =

D1 =
D2 =
D3 =
D4 =
D5 =

This responds to your letter dated June 12, 2000, submitted on behalf of X requesting relief under section 1362(f) of the Internal Revenue Code.

FACTS

X incorporated under the laws of State on D1 and elected to be treated as a subchapter S corporation effective D2. On D3, X issued stock to A, a corporation, giving A a a% interest in X. On D4, X issued stock to B, a corporation, giving B a b% interest in X. On D5, X issued stock to C, a corporation, giving C a c% interest in X. X, its incorporators, and shareholders intended for X to be an S corporation before and after the issuance of the X stock to A, B, and C. When it was discovered that A, B, and C were not permissible S corporation shareholders, immediate steps were taken to redeem their entire interests in X at a price equal to A, B, and C’s original purchase price for the stock. X and all of its shareholders have agreed to make such adjustments as are determined appropriate for X to retain its S status.

LAW AND ANALYSIS
2
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Section 1361(a)(1) defines an "S corporation" as "a small business corporation for which an election under section 1362 is in effect."

Section 1361(b)(1)(B) provides that, in order to be a small business corporation, a taxpayer cannot have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual.

Section 1362(d)(2)(A) provides that an election to be treated as a subchapter 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) such corporation ceases to be a small business corporation. Under section 1362(d)(2)(B), the termination is effective on and after the date the S corporation ceases to meet the requirements of a small business corporation.

Section 1362(f), in relevant part, provides that if (1) an election under section 1362(a) by any corporation was terminated under section 1362(d), (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 the 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 section 1362(f), agrees to make any adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to the 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.

The committee reports accompanying the Subchapter S Revision Act of 1982 explain section 1362(f) 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 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, 3
PLR-116274-00
or retroactive for the period in which the corporation again became eligible for subchapter S treatment, depending on the facts.

S. Rep. No. 640, 97th Cong., 2d Sess. 12-13 (1982), 1982-2 C.B. 718, 723-24;
H.R. Rep. No. 826, 97th Cong., 2d Sess. 12 (1982), 1982-2 C.B. 730, 735.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that X’s election to be treated as an S corporation terminated on D3 when X’s stock was issued to A. We also conclude that the termination constituted an "inadvertent termination" within the meaning of section 1362(f). Pursuant to section 1362(f), X will be treated as continuing to be an S corporation from D3, provided that the items of income, deduction, and credit of the S corporation which would have been allocated to A, B, and C are allocated to the other shareholders in accordance with their stock ownership in X (as if A, B, and C had not been shareholders), and that X’s S election is not otherwise terminated under section 1362(d).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether the original election made by X to be treated as an S corporation was a valid election under section 1362.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,
Christopher T. Kelley
Acting Assistant Branch Chief
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

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