PLR 200114009: S status restored after stock issued to ineligible owners

Plain-English summary

An S corporation issued shares to three corporations and two partnerships, none of which could be S corporation shareholders. The IRS determined that S status ended when the first ineligible corporation acquired stock, but that the termination was inadvertent under IRC § 1362(f). The company moved to remove the ineligible owners after discovering the problem, and the IRS allowed it to be treated as continuing as an S corporation. That relief required income, deductions, and credits otherwise allocated to the ineligible owners to be allocated to the other shareholders as if the ineligible owners had never held shares. It also depended on the S election not ending for another reason; the IRS did not decide whether the original election was valid.

Ruling snapshot

• Question: Can the corporation keep S status after issuing stock to ineligible corporate and partnership owners?
• Outcome: Approved, with allocation adjustments and no other termination
• 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: 200114009 Washington, DC 20224
Release Date: 4/6/2001
Index Number: 1362.04-00 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:1-PLR-116949-00
Date:
Dec 22, 2000

Legend:

X =

A =

B =

C =

D =

E =
a = b = c = d = e =

State =

D1 =
D2 =
D3 =
D4 =
D5 =
D6 =
D7 =
D8 =
 2
PLR-116949-00

This responds to your letter dated August 24, 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 D1. On D2, X issued stock to A, a corporation, giving A a a% interest in X. On D3, X issued stock to B, a corporation, giving B a b% interest in X. On D4 and D5, X issued stock to C, a corporation, giving C a c% interest in X. On D6 and D7, X issued stock to D, a partnership, giving D a d% interest in X. On D8, X issued stock to E, a partnership, giving E a e% 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, C, D, and E. When it was discovered that A, B, C, D, and E were not permissible S corporation shareholders, immediate steps were taken to sell their entire interests in X. 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

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 3 PLR-116949-00

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, 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 D2 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 D2, provided that the items of income, deduction, and credit of the S corporation which would have been allocated to A, B, C, D, and E are allocated to the other shareholders in accordance with their stock ownership in X (as if A, B, C, D, and E 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 4 PLR-116949-00

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

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