PLR 200344005: Ineligible shareholder does not end S status after relief

Plain-English summary

An S corporation transferred stock to an ineligible shareholder, which terminated its S election. The corporation said the transfer was not part of tax avoidance or retroactive tax planning and that it promptly took corrective steps after discovering the issue. The IRS found the termination inadvertent under IRC § 1362(f). It treated the corporation as continuing to have S status from the transfer date, assuming its election was otherwise valid and had not terminated for another reason. The IRS did not decide whether the corporation otherwise qualified as a valid S corporation.

Ruling snapshot

• Question: Could the corporation retain S treatment after stock was transferred to an ineligible shareholder?
• Outcome: Approved, assuming its S election was otherwise valid.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(d)(2), and 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200344005
Washington, DC 20224
Release Date: 10/31/2003
Index Number: 1362.04-00; 1362.02-02; Person to Contact:
1361.01-02
Telephone Number:

Refer Reply To:
CC:PSI:B1-PLR-132576-03
Date:
July 29 2003

Legend:

X
=

State =

D1
=

D2
=

Dear
:

This responds to a letter dated May 12, 2003, together with related documents, submitted on behalf of X, requesting a ruling under §1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted, X was incorporated under the laws of State.
X elected to be treated as a Subchapter S corporation for federal taxation purposes effective D1. The stock of X was transferred to an ineligible shareholder on D2. Consequently, X’s S election terminated on D2.

X represents that the transfer of its stock to an ineligible shareholder was not motivated by tax avoidance or retroactive tax planning. Further, upon discovering the terminating event, X and its shareholders immediately took steps to return X to a small business corporation and agree to make any adjustments consistent with the treatment of

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X as an S corporation as may be required by the Secretary with respect to the period specified by §1362(f) of the Code.

LAW AND ANALYSIS

Section 1361(a)(1) defines an “S corporation”, with respect to any taxable year, as a small business corporation for which an S election under §1362(a) is in effect for such year.

Section 1361(b)(1)(B) provides that a small business corporation cannot 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.

Section 1362(d)(2)(A) provides that an election under §1362(a) shall be terminated whenever (at any time on or after the first day of the taxable year for which the corporation is an S corporation) the corporation ceases to be a small business corporation. The termination is effective on and after the day of the cessation. §1362(d)(2)(B).

Section 1362(f), in relevant part, provides that, if: (1) an election under §1362(a) by any corporation was terminated under §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 in the corporation at any time during the period specified pursuant to §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 such 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 §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 consequence of a termination if no tax avoidance would result from the continued subchapter S treatment. In granting a waiver, it is hoped that the taxpayers and the government will work out agreements that protect the revenues without undue hardship to taxpayers . . . . It

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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.

CONCLUSIONS

Based solely on the facts submitted and the representations made, we conclude that X’s Subchapter S election terminated on D2 when X’s stock was transferred to an ineligible shareholder. We also conclude that the termination constituted an “inadvertent termination” within the meaning of §1362(f).

Further, we conclude that, pursuant to §1362(f), X will be treated as continuing to be an S corporation from D2, assuming X’s S corporation election is valid and not otherwise terminated under §1362(d).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of the facts described above under any other provision of the Code. Specifically, no opinion is expressed concerning whether X is a valid S corporation.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) 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 mailed to X.

Sincerely,

Dianna K. Miosi
Chief, Branch 1
Associate Chief Counsel
(Passthroughs and Special Industries)
Enclosures (2)
Copy of this letter
Copy for § 6110 purposes