PLR 200119040: Possible S corporation election termination treated as inadvertent

Plain-English summary

An S corporation converted into a state law limited partnership that elected to be taxed as a corporation. It later converted back after learning that the partnership form might have created a second class of stock and ended its S election. The IRS did not decide whether the conversion actually caused that problem. It ruled that, if the election had terminated for that reason, the termination was inadvertent under section 1362(f). The corporation would continue to be treated as an S corporation during the partnership period and afterward unless its election otherwise ended.

Ruling snapshot

• Question: If the conversion created a second class of stock and ended the S election, was the termination inadvertent?
• Outcome: Approved conditionally, with continued S corporation treatment during and after the partnership period.
• Key authorities: IRC §§ 1361(b)(1)(D) and 1362(f); Treas. Reg. §§ 1.1362-4(b) and 301.7701-3.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200119040
Washington, DC 20224
Release Date: 5/11/2001
Index Number: 1362.04-00
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:Br.3-PLR-103366-01
Date:
February 8, 2001

Legend

A
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Company =

Partnership =

LLC =

State =

D1
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D2
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D3
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D4
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D5
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Dear

This letter responds to a letter from your authorized representatives dated January 2, 2001, submitted on behalf of Company, requesting a ruling under section 1362(f) of the Internal Revenue Code that the termination of Company’s S corporation election, if it occurred, was inadvertent. Company represents the following facts.

FACTS

Company was incorporated in State on D1 and elected under section 1362(a) to be an S corporation effective D2. A was Company’s sole shareholder.

Company decided to convert to a limited partnership under the State Revised 2
PLR-103366-01

Limited Partnership Act. Company represents that its motive for conversion was the reduction of its State franchise tax and not avoidance of federal tax.

To effect the conversion, A formed LLC, contributing some of his Company stock in exchange for all of the interests in LLC. On D3, Company filed Articles of Conversion, effective D4, converting Company into Partnership. LLC was named the general partner, and A the limited partner of Partnership. Each unit in Partnership held by the partners, general and limited, carried the same economic rights.

Partnership elected under section 301.7701-3 of the Procedure and Administration Regulations to be treated as an association taxable as a corporation effective D4. Partnership believed that the conversion would be treated for federal income tax purposes as a reorganization under section 368(a)(1)(F) and that Company’s S corporation election would be unaffected by the conversion.

On December 27, 1999, Rev. Proc. 99-51, 1999-2 C.B. 760, announced that the Internal Revenue Service would not rule on whether a state law limited partnership electing to be classified as an association for federal tax purposes has more than one class of stock under section 1361(b)(1)(D). Realizing for the first time that Company’s conversion to a State limited partnership might have terminated its S corporation election, Partnership converted back to a State corporation on D5. Company represents that it had no plan to terminate its S election.

LAW AND ANALYSIS

Except as provided in section 1362(g), section 1362(a)(1) provides that a small business corporation may elect, in accordance with the provisions of section 1362, to be an S corporation.

Section 1361(b)(1)(D) provides that, for purposes of subchapter S, the term "small business corporation" means a domestic corporation that is not an ineligible corporation and that does not, among other things, have more than one class of stock.

Section 1362(d)(2)(A) provides that an election under section 1362(a) terminates whenever the corporation ceases to be a small business corporation.

Section 1362(f) provides that if (1) an election under section 1362(a) by any corporation was terminated under section 1362(d)(2) or (3); (2) the Secretary determines that the circumstances resulting in termination were inadvertent; (3) no later than a reasonable period of time after discovery of the circumstances resulting in termination, 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 section 1362(f), agrees to make the adjustments (consistent with the treatment of the corporation as an S corporation) as 3 PLR-103366-01

might be required by the Secretary regarding this period, then, notwithstanding the circumstances resulting in termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1.1362-4(b) of the Income Tax Regulations provides that the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the event took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event, tends to establish that the termination was inadvertent.

According to the legislative history of section 1362(f) –

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.

The Internal Revenue Service is studying the issue of whether a state law limited partnership electing under section 301.7701-3 to be classified as an association taxable as a corporation has more than one class of stock for purposes of section 1361(b)(1)(D). Until the Service resolves this issue through published guidance, letter rulings will not be issued. The Service will treat any request for a ruling on whether a state law limited partnership is eligible to elect S corporation status as a request for a ruling on whether the partnership complies with section 1361(b)(1)(D). Rev. Proc. 2001-3, section 5.05, 2001-1 I.R.B. 111, 119, based on Rev. Proc. 99-51, 1999-2 C.B. 760. 4 PLR-103366-01

Based solely on the facts as represented by Company in this ruling request, we conclude that if Company’s conversion from a State corporation to a State limited partnership did create a second class of stock, the consequent termination of Company’s S corporation election was inadvertent within the meaning of section 1362(f).

Therefore, we rule that Company will continue to be treated as an S corporation for the period from D4 to D5, and thereafter, unless Company’s S election otherwise terminates 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.

This ruling is directed only to the taxpayer(s) 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, we are sending a copy of this letter to your authorized representative.

Sincerely,
Mary Beth Collins
Assistant to the Branch Chief, Branch 3
Office of the Associate Chief Counsel
(Passthroughs and Special Industries) cc: