PLR 200448037: Company can keep S corporation status after passive income termination

Plain-English summary

An S corporation had accumulated earnings from its earlier C corporation years and exceeded the passive investment income threshold for three consecutive years. Its S election therefore terminated under Section 1362(d)(3). The IRS found the termination inadvertent and allowed the corporation to be treated as an S corporation from the termination date forward, subject to conditions. Within 60 days, the corporation had to amend its return to elect a deemed dividend distribution, its shareholder had to amend an individual return, and the corporation had to make a specified payment. The ruling would be void if those conditions were not met.

Ruling snapshot

• Question: Could the corporation retain S status after three years of excess passive investment income ended its election?
• Outcome: Approved inadvertent termination relief, conditional on amended returns and payment within 60 days.
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1368, 1375; Treas. Reg. § 1.1368-1(f)(3).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200448037
Release Date: 11/26/04
Index Number: 1362.04-00

------------------------------------------- Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B02 – PLR-150328-03
Date:
August 4, 2004

X = ---------------------------------
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A = ----------------------------------
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D1 = -------

D2 = ----------------

D3 = ----------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

$x = -------------

$y = ----------

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

This letter responds to a letter dated August 13, 2003, and prior correspondence, submitted on behalf of X by X’s authorized representative, requesting a ruling under ' 1362(f) of the Internal Revenue Code.

The information submitted states that X was incorporated in D1. X elected to be treated as an S corporation effective D2. X had subchapter C earnings and profits at the close of each of its Year 1, Year 2, and Year 3 taxable years, and had gross 2 PLR-150328-03

receipts for each of those years more than 25 percent of which were passive investment income. As a result, X=s S election terminated on D3. X also did not pay the tax under
§ 1375 for Year 1 and Year 2.

X represents that the termination of X=s election to be an S corporation was inadvertent, unintended, and not the result of tax avoidance or retroactive tax planning. X and A agree to make any adjustments consistent with the treatment of X as an S corporation as may be required by the Secretary.

Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under ' 1362(a) is in effect for the taxable year.

Section 1361(b)(1)(B) provides that a "small business corporation" means a domestic corporation that is not an ineligible corporation and that does not 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)(3)(A)(i) provides that an election under ' 1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close of each of three consecutive taxable years, and has gross receipts for each of such years more than 25 percent of which are passive investment income. Section 1362(d)(3)(A)(ii) provides that any termination under ' 1362(d)(3) shall be effective on and after the first day of the first taxable year beginning after the third consecutive taxable year referred to in ' 1362(d)(3)(A)(i).

Section 1362(f) provides that if (1) an election under ' 1362(a) by any corporation was terminated under ' 1362(d)(2) or 1362(d)(3); (2) the Secretary determines that the circumstances resulting in such termination were inadvertent; (3) no later than a reasonable period of time after discovery of the circumstances resulting in the 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 under ' 1362(f), agrees to make the adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary for that period, then, notwithstanding the circumstances resulting in such termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1368(c) provides rules for determining the source of distributions made by an S corporation having accumulated earnings and profits with respect to its stock. Section 1368(e)(3) and § 1.1368-1(f)(2)(iii) of the Income Tax Regulations provide that an S corporation may, with the consent of all of its affected shareholders, elect to distribute earnings and profits first. 3 PLR-150328-03

Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or part of its accumulated earnings and profits through a deemed dividend. If an S corporation makes the election provided in § 1.1368-1(f)(3), the S corporation will be considered to have made the election under § 1368(e)(3) and § 1.1368-1(f)(2)(iii) to distribute earnings and profits first.

Section 1375 imposes a tax on the income of an S corporation that has accumulated earnings and profits at the close of a taxable year, and that has gross receipts more than 25 percent of which are passive investment income (within the meaning of ' 1362(d)(3)).

Based solely on the representations made and the information submitted, including the information that was submitted and used to calculate the adjustment described below, we conclude that X's S corporation election terminated on D3 under ' 1362(d)(3)(A), because X had subchapter C earnings and profits at the close of each of three consecutive taxable years, and had gross receipts for each of those taxable years more than 25 percent of which were passive investment income.

We further conclude that the termination of X's S corporation election was an inadvertent termination within the meaning of ' 1362(f). Accordingly, pursuant to the provisions of ' 1362(f), X will be treated as continuing to be an S corporation beginning D3, and thereafter, provided that X's S corporation election was valid and has not otherwise terminated under ' 1362(d) and provided that the following conditions are met. Within 60 days from the date of this letter, X shall file an amended return for the Year 3 taxable year, electing pursuant to § 1.1368-1(f)(3) to make a deemed dividend distribution of $x. Also within 60 days, A shall amend A’s individual Year 3 income tax return to reflect the changes made to X's Year 3 return. In addition, as an adjustment under § 1362(f)(4), X must send a payment of $y attached to a copy of this letter to the following address: Internal Revenue Service, P. O. Box 9940, Mail Stop 6271, Ogden, UT 84409. If these conditions are not met, then this ruling is null and void. Furthermore, if these conditions are not met, X must notify the Ogden Service Center with which X's S corporation election was filed that the election terminated on D3.

Except as specifically ruled upon above, no opinion is expressed concerning the federal income tax consequences of the above-described facts under any other provision of the Code.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that it may not be used or cited as precedent. 4 PLR-150328-03

In accordance with the power of attorney on file with this office, a copy of this letter is being sent to X’s authorized representative.

Sincerely,

J. Thomas Hines
Chief, Branch 2
Office of Associate Chief Counsel

(Passthroughs & Special Industries)

Enclosures: 2
Copy of this letter
Copy for ' 6110 purposes