PLR 200444017: S corporation election restored after stock briefly entered a trust

Plain-English summary

Before selling his shares in an S corporation, a shareholder transferred them to a trust that was not an eligible S corporation shareholder. That transfer terminated the company's S election, but the seller and company had not intended that result, and the shares were soon sold to other purchasers. The IRS ruled that the termination was inadvertent and that the company would continue to be treated as an S corporation. The ruling required the trust not to be treated as a shareholder while it held the shares. Other shareholders had to report the tax items attributable to those shares and make corresponding basis and distribution adjustments.

Ruling snapshot

• Question: Was the S corporation election's termination caused by a brief transfer to an ineligible trust inadvertent?
• Outcome: Approved, subject to the stated tax adjustments.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(d)(2), 1362(f), 1366–1368; Treas. Reg. § 1.1362-4.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200444017
Release Date: 10/29/04
Index Number: 1362.04-00

----------------------------
Person To Contact:
-----------------------------
--------------------, ID No. -------------
---------------------------
Telephone Number:
-----------------------------------
---------------------
Refer Reply To:
CC:PSI:3 / PLR-169698-03
-
Date:
-
July 12, 2004

Company: -----------------------------
-----------------------

Shareholders: --------------------
-------------------------------------------------------
----------------------------------------------
-------------------------------------------------------

Purchasers: ------------------
-------------------------------------------------------
-----------------------------------------
-------------------------------------------------------
-------------------------------------------
-------------------------------------------------------
-------------------------------------------
-------------------------------------------------------

Seller: -------------------

Trust: -----------------------------------------------------------------------------
---------------------------------------------------------

State: -------------

a: ---------------------

b: -----------------------

c: -------------------------

d: -------------------------

2
PLR-169698-03

Dear --------------:

This letter responds to a letter from your authorized representative dated December 5, 2003, 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 was incorporated on a under the laws of State and elected under ' 1362(a) to be an S corporation effective that same date. On or about b, Purchasers began negotiating with Seller for the purchase of all of his shares of stock in Company. On the advice of his estate planning consultant, and without the knowledge of Company or Purchasers, Seller formed the Trust. Seller transferred all of his Company shares to the Trust on c, with the Trust selling those shares to Purchasers on d.

The Trust is not a permitted shareholder of an S corporation under ' 1361(b)(1)(B). The termination of Company=s S corporation election due to the transfer of stock to an ineligible shareholder was discovered shortly after the sale when the Purchasers’ corporate counsel consulted with Purchasers’ tax counsel.

Seller was not aware that the transfer of stock to the Trust would terminate Company=s S corporation election. Company, Shareholders, Purchasers, and the Trust 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 Asmall 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 ' 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.

3
PLR-169698-03

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).

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 Trust was inadvertent within the meaning of ' 1362(f). Consequently, we rule that Company will continue to be treated as an S corporation from c, and thereafter, unless Company's S election otherwise terminates under ' 1362(d).

As a condition for this ruling, the Trust must not be treated as a shareholder for any time it held Company shares. Accordingly, for the time the Trust did hold Company

4
PLR-165091-03

shares, 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,

CHRISTINE E. ELLISON
Chief, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosure: copy of this letter copy for ' 6110 purposes