PLR 200528006: Ineligible shareholder does not defeat corrected S election

Plain-English summary

A corporation's S election was invalid because one shareholder was ineligible when the election took effect. After its tax advisors discovered the problem, the corporation took steps to make that shareholder eligible. The IRS found the invalid election inadvertent under IRC § 1362(f) and allowed the corporation to be treated as an S corporation from its intended effective date. The relief depends on the election not otherwise terminating, and the corporation and shareholders agreed to any adjustments the IRS might require.

Ruling snapshot

• Question: Can an initially invalid S election be treated as effective after correcting an ineligible shareholder?
• Outcome: Approved; S corporation treatment continues from the intended date under IRC § 1362(f).
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200528006
Third Party Communication: None
Release Date: 7/15/2005
Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B01
PLR-112859-05
Date:
April 01, 2005

Legend

X = ---------------------------
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Y = ---------------------
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State = ----------

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

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

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

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

This responds to a letter dated March 2, 2005, submitted on behalf of X, requesting relief for an inadvertent invalid subchapter S election 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. X elected to be an S corporation effective on D2. It was discovered that at the time of the S corporation election, a portion of the stock of X was held by an ineligible shareholder, Y. Prior to D3, X was informed by its tax advisors of the invalid election. To rectify the situation, steps were taken to cause Y to become an eligible shareholder on D3.
PLR-112859-05
2

X and its shareholders have agreed to make any adjustments that the Commissioner may require consistent with the treatment of X as an S corporation.

LAW AND ANALYSIS

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

Section 1361(b)(1)(B) provides that an S 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) will be terminated whenever (at any time on or after the 1st day of the 1st taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation. Section 1362(d)(2)(B) provides that the termination shall be effective on and after the date of cessation.

Section 1362(f) provides in relevant part that if (1) an election under § 1362(a) by any corporation was not effective for the taxable year for which made (determined without regard to subsection (b)(2)) by reason of a failure to meet the requirements of § 1361(b) or to obtain shareholder consents, (2) the Secretary determines that the circumstances resulting in such ineffectiveness were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness, 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 in 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 ineffectiveness, such corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

Based solely upon the facts submitted and the representations set forth above, we conclude that X’s S election was ineffective for the taxable year beginning on D2. We also conclude that the ineffectiveness of X’s S election constituted an inadvertent invalid election within the meaning of § 1362(f).

Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation from D2 and thereafter, provided that X’s subchapter S election is not otherwise terminated under § 1362(d).
PLR-112859-05
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Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the above-described facts under any other provision of the Code.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

Pursuant to a power of attorney on file with this office, a copy of this letter is being sent to your authorized representatives.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

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

cc: