PLR 200523001: Corporation keeps S status after inadvertent passive income termination

Plain-English summary

An S corporation had accumulated earnings and profits and received more than 25 percent of its gross receipts from passive investment income in each of three consecutive years. That combination terminated its S election under IRC § 1362(d)(3). After discovering the problem, the corporation distributed its accumulated earnings and profits. It and its sole shareholder agreed to amend a return to reflect additional tax under § 1375, and the corporation represented that it had paid that tax for the other two years. The IRS found the termination inadvertent under § 1362(f) and treated the corporation as continuing to be an S corporation from the termination date, unless another termination occurred. It required no further adjustments under § 1362(f)(4) on these facts.

Ruling snapshot

• Question: Could the corporation retain its S status after a three-year passive income termination?
• Outcome: Approved as an inadvertent termination.
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1375; Treas. Reg. § 1.1362-4.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200523001
Third Party Communication: None
Release Date: 6/10/2005
Date of Communication: Not Applicable
Index Number: 1362.02-00, 1362.02-03,
1362.04-00
Person To Contact:
-----------------------, ID No. -------------
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Telephone Number:
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Refer Reply To:
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CC:PSI:B01
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PLR-100974-05
Date:
March 03, 2005

Legend

X = -----------------------------------
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SH = ---------------------
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State = --------------

D1 = --------------------------

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

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

D4 = ----------------------

D5 = ----------------------

D6 = --------------------------

D7 = -------------------------

$a = ---------------
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Dear ------------:

This responds to a letter dated December 21, 2004, sent by your authorized representative, requesting inadvertent termination relief under §1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted, X was incorporated on D1 pursuant to the laws of State. SH, X’s sole shareholder, elected for X to be treated as an S corporation effective D2. In the consecutive taxable years ending D3, D4, and D5, X received passive investment income (within the meaning of § 1362(d)(3)) in excess of 25% of its gross receipts. Furthermore, X had accumulated earnings and profits (AE&P) remaining in each of these three years. As a result, X’s S election terminated effective on D6.

On or around D7, X discovered that it had inadvertently terminated its S corporation status. X requested this ruling shortly thereafter, and distributed $a, a figure which represents the entire amount of AE&P held by X. X and SH represent that each will file an amended return for the taxable year ending D3 to reflect the additional tax owed pursuant to § 1375. In addition, X represents that it paid the tax imposed by § 1375 for the taxable years ending D4 and D5.

X represents that the termination of its S election was inadvertent and not the result of tax avoidance or retroactive tax planning. X and its sole shareholder SH have consistently treated X as an S corporation and agree to make any adjustments consistent with the treatment of X as an S corporation that may be required by the Secretary.

LAW AND ANALYSIS

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 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 the taxable years more than 25% of which are passive investment income. The termination is effective on and after the first date of the first taxable year beginning after the third consecutive taxable year referred to in § 1362(d)(3)(A)(i). Section 1362(d)(3)(A)(ii).

Except as otherwise provided in § 1362(d)(3)(C), § 1362(d)(3)(C)(i) provides that the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.
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Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation (A) 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 consent, or (B) was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in such ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in the termination, steps were taken - (A) so that the corporation is a small business corporation, or (B) to acquire the required shareholder consents, and (4) the corporation, and each person who was a shareholder of 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 termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1.1362-4(b) of the Income Tax Regulations 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.

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% of which are passive investment income (within the meaning of § 1362(d)(3)).

CONCLUSION

Based solely upon the representations made and the information submitted, we conclude that X’s S election terminated effective D6 because X had AE&P at the close of each of three consecutive tax years and had gross receipts for each of those tax years more than 25 percent of which were passive investment income.

We further conclude that the termination of X’s S election was an inadvertent termination within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X
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will be treated as continuing to be an S corporation on and after D6, unless X’s S election is otherwise terminated under § 1362(d). Based upon the particular facts of this case, no adjustments are required under § 1362(f)(4).

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(s) requesting 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 sent to X’s authorized representative.

Sincerely,

/s/Dianna K. Miosi
Dianna K. Miosi
Chief, Branch 1
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)

Copy of this letter
Copy for section 6110 purposes