PLR 200246026: Ineligible trust shareholder does not defeat S corporation treatment

Plain-English summary

A corporation elected S corporation status while one of its shareholders was an ineligible trust, making the election ineffective. After discovering the problem, the trust transferred its shares to another trust represented to be eligible. The IRS found the invalid election inadvertent under section 1362(f) and ruled that the corporation would be treated as an S corporation from the original effective date, unless the election later terminated for another reason. The relief depended on the corporation and specified shareholders treating it as an S corporation and the new trust as a shareholder from that date. The IRS did not otherwise determine the corporation's eligibility for an S election or its subsidiary's QSub status.

Ruling snapshot

• Question: Could the corporation retain S corporation treatment despite an ineligible trust shareholder when it first elected?
• Outcome: Approved: inadvertent invalid election relief under section 1362(f), subject to the stated conditions.
• Key authorities: IRC §§ 1361(b), 1361(c)(2), 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200246026
Washington, DC 20224
Release Date: 11/15/2002
Index Number: 1362.04-00
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-121635-02
Date:
August 15, 2002

LEGEND

Corporation =

Subsidiary =

A
=

B
=

Trust 1
=

Trust 2
=

State
=

Date 1
=

Date 2
=

Date 3
=

m
=

Dear :

This letter responds to a letter dated April 4, 2002, and subsequent correspondence, requesting a ruling under § 1362(f) of the Internal Revenue Code.

Facts

Corporation was incorporated on Date 1 under State law and elected to be an S corporation effective Date 2. Also effective Date 2, Corporation elected to treat Subsidiary as a qualified subchapter S subsidiary (QSub). As of Date 2, A, B, and

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Trust 1 each owned m shares of Corporation stock.

On or about Date 3, Corporation learned that Trust 1 was an ineligible shareholder, and, thus, its S corporation election was invalid. Shortly thereafter, Trust 1 transferred its Corporation stock, m shares, to Trust 2. It is represented that Trust 2 is an eligible shareholder under § 1361(c)(2)(A)(i).

Corporation and its shareholders represent that the invalid S corporation election was inadvertent and was not motivated by tax avoidance or hindsight. Corporation and its shareholders agree to make any adjustments, consistent with the treatment of Corporation as an S corporation, that the Secretary may require with respect to the period specified by § 1362(f).

Applicable Law

Section 1361(a)(1) generally provides that the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under § 1362(a) is in effect for such year.

Section 1361(b)(1) provides that the term "small business corporation" means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 75 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in § 1361(c)(2), or an organization described in § 1361(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(b)(3)(B) defines a QSub as any domestic corporation that is not an ineligible corporation, if 100 percent of the stock of the corporation is owned by an S corporation, and the S corporation elects to treat the corporation as a QSub.

Section 1362(a) provides, in part, that a small business corporation may elect to be an S corporation.

Section 1362(d)(2)(A) provides that an election under § 1362(a) is terminated 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. Section 1362(d)(2)(B) provides that such termination is effective on and after the date the S corporation ceases to be a small business corporation.

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation was not effective for the taxable year for which made (determined without regard to § 1362(b)(2)) by reason of a failure to meet the requirements of § 1361(b) or to obtain shareholder consents, (2) the Secretary determines that the circumstances resulting in such ineffectiveness were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness, steps

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were taken so that the corporation is a small business corporation, or to acquire the required shareholder consents, and (4) the corporation, and each person who was a shareholder in the corporation at any time during the period specified pursuant to this subsection, agrees to make such adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to such period, then, notwithstanding the circumstances resulting in such ineffectiveness, such corporation shall be treated as an S corporation during the period specified by the Secretary.

Conclusion

Based on the facts submitted and the representations made, we conclude that Corporation's S corporation election was ineffective for the taxable year beginning Date 2 because Trust 1 was an ineligible shareholder of Corporation. We also conclude that the ineffectiveness of Corporation’s S corporation election constituted an inadvertent invalid election under § 1362(f). Therefore, we rule that Corporation will be treated as an S corporation beginning Date 2 and thereafter, unless Corporation’s S corporation election otherwise terminates under § 1362(d).

This ruling is contingent on Corporation and all its shareholders, A, B, and Trust 2, treating Corporation as an S corporation effective Date 2, and on Corporation treating A, B, and Trust 2 as the shareholders of Corporation as of Date 2.

Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provision of the Code. Specifically, no opinion is expressed regarding the eligibility of Corporation to have elected under § 1362(a) to be an S corporation or of Subsidiary to be a QSub.

This ruling is directed only to the taxpayer who 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, we are sending a copy of this letter to your authorized representatives.

Sincerely yours,
Mary Beth Collins
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

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