PLR 200306029: Inadvertent trust transfers do not end S corporation treatment

Plain-English summary

Shareholders transferred part of their S corporation stock to trusts that could not own S corporation shares, which terminated the company's S election. They said they had not known the transfers would cause that result. The IRS found the termination inadvertent under § 1362(f) and allowed the company to be treated as an S corporation from the transfer date onward. The shareholders had to reacquire the shares from the trusts within 60 days, and the trusts could not be treated as shareholders while they held the stock. The shareholders instead had to report the income and basis effects attributable to those shares under §§ 1366 through 1368.

Ruling snapshot

• Question: Was the S election termination caused by stock transfers to ineligible trusts inadvertent?
• Outcome: Approved, subject to reacquiring the shares and treating the shareholders as owners for tax purposes.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(f), and 1366 through 1368; Treas. Reg. § 1.1362-4.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Number: 200306029
Washington, DC 20224
Release Date: 02/07/2003
Index Number: 1362.04-00 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-139064-02
Date:
November 4, 2002

Legend

Company:

State:

Shareholders:

Trusts:

a:
b:
c:
d:
 2
PLR-139064-02
e:

Dear
:

This letter responds to a letter from your authorized representative dated June 14, 2002, as well as additional correspondence, submitted on behalf of Company, requesting a ruling under § 1362(f) of the Internal Revenue Code that the termination of Company's S corporation election was inadvertent.

FACTS

Company represents the following facts. Company was incorporated on a under the laws of State and elected under § 1362(a) to be an S corporation effective b. On the advice of their financial planner and their attorney, Shareholders formed the Trusts in late c, to which they transferred portions of their Company shares on d. The Trusts are not permitted shareholders of an S corporation under § 1361(b)(1)(B). The termination of Company’s S corporation election due to the transfer of stock to ineligible shareholders was discovered by an accountant as he was preparing the e tax return for one of the shareholders.

Neither Company nor Shareholders were aware that the transfer of stock to the Trusts would terminate Company’s S corporation election. Company filed Form 1120S, U.S. Income Tax Return for an S Corporation, for its e tax year, and Shareholders filed Forms 1040, U.S. Individual Income Tax Returns, for the same year consistent with Company being an S corporation. The Trusts were not treated as shareholders.

Company, Shareholders, and the Trusts agree to make adjustments during the termination period (consistent with the treatment of Company as an S corporation) as may be required by the Service.

LAW

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

Section 1361(b)(1)(B) 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 as a shareholder a person (other than an estate, a trust described in § 1361(c)(2), or an organization described in 3 PLR-139064-02

§ 1361(c)(6)) who is not an individual.

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

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation was terminated under § 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 § 1362(f), agrees to make the adjustments (consistent with the treatment of the corporation as an S corporation) as 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) 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.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the Commissioner. In the case of a transfer of stock to an ineligible shareholder that causes an inadvertent termination under § 1362(f), the Commissioner may require the ineligible shareholder to be treated as a shareholder of an S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the Commissioner may require protective adjustments that prevent any loss of revenue due to a transfer of stock to an ineligible shareholder (e.g., a transfer to a nonresident alien). 4 PLR-139064-02

CONCLUSION

Based on the facts and representations submitted by Company, we conclude that the termination of Company's S corporation election due to the transfer of Company stock to the Trusts was inadvertent within the meaning of § 1362(f). Consequently, we rule that Company will continue to be treated as an S corporation

from d, and thereafter, unless Company's S election otherwise terminates under
§ 1362(d).

As a condition for this ruling, Shareholders must reacquire the Company shares now held by the Trusts within 60 days of the date of this letter, and the Trusts must not be treated as shareholders for any time they held these shares. Accordingly, Shareholders must include the prorata share of the separately and nonseparately computed items attributable to those shares in their income as provided in § 1366, make adjustments to the stock basis of those shares as provided in § 1367, and take into account any distributions with respect to those shares as provided in § 1368.

Except for the specific ruling above, no opinion is expressed or implied concerning the federal income tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed or implied regarding Company's eligibility to be an S corporation.

Under a power of attorney on file with this office, we are sending a copy of this letter to your authorized representative.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3), this ruling may not be used or cited as precedent.

Sincerely,

/s/
JAMES A. QUINN
Senior Counsel, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosure: copy of this letter copy for § 6110 purposes