PLR 200606026: Inadvertent invalid S election cured for trust shareholders

Plain-English summary

A corporation elected S status, but one shareholder trust had not made an electing small business trust (ESBT) election, making the corporation's S election invalid. A second ineligible trust later became a shareholder without making its ESBT election. The IRS accepted the corporation's representation that the failures were inadvertent and ruled under section 1362(f) that it would be treated as an S corporation from the original effective date, provided its election was not otherwise invalid or terminated. Each trust would be treated as an ESBT from the relevant date if its trustee filed the required election within 60 days of the letter. The shareholders also had to report and adjust their tax items consistently with S corporation treatment.

Ruling snapshot

• Question: Could the corporation keep S treatment despite two shareholder trusts' missing ESBT elections?
• Outcome: Approved inadvertent invalid election relief, subject to corrective filings and consistent tax treatment.
• Key authorities: IRC §§ 1361(e), 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200606026
Release Date: 2/10/2006
Index Number: 1362.04-00

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Person To Contact:
-------------------------------------------------- --------------------, ID No. -------------
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Telephone Number:
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Refer Reply To:
CC:PSI:B02 – PLR-142490-05
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Date:
October 25, 2005

X = --------------------------------------------------
EIN: -----------------------------------

A = ------------------
SSN: -----------------

Trust 1 = --------------------------------
EIN: ----------------

Trust 2 = ------------------------------------
EIN: ----------------

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

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

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

This letter responds to a letter dated May 9, 2005, and subsequent correspondence submitted on behalf of X, requesting relief under ' 1362(f) of the Internal Revenue Code.

The information submitted states that X was formed D1. Effective D1, X elected to be an S corporation. On D1, Trust 1 was a shareholder of X. However, Trust 1 was an ineligible shareholder and therefore, X’s election to be an S corporation was invalid. A, the president of X, represents that Trust was qualified to be an electing small business trust (“ESBT”) effective D1. However, the trustee of Trust 1 failed to make an ESBT election effective D1. Additionally, Trust 2, an ineligible shareholder, became a shareholder of X on D2. A represents that Trust 2 was qualified to be an electing small business trust effective D2. The trustee of Trust 2 failed to make an ESBT election

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effective D2. A represents that X filed Form 1120S, U.S. Income Tax Return for an S corporation, for all the years involved in this request.

A represents that the circumstances resulting in X=s invalid election to be an S corporation were inadvertent. Additionally, A represents that X and its shareholders did not intend to engage in tax avoidance or retroactive tax planning. X and its shareholders agree to make such adjustments (consistent with the treatment of X as an S corporation) as may be required by the Secretary with respect to such period.

Section 1362(a) provides that, except as provided in ' 1362(g), a small business corporation may elect, in accordance with the provisions of ' 1362, to be an S corporation.

Section 1361(a)(1) provides that the term AS 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 a Asmall 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, in general, an election to be treated as an S corporation shall be terminated whenever (at any time on or after the first day of the first taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1361(c)(2)(A)(v) provides that an Aelecting small business trust@ may be a shareholder in an S corporation.

Section 1361(e)(1)(A) provides that the term Aelecting small business trust@ means any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, or (III) an organization described in paragraph (2), (3), (4), (5) of ' 170(c), (ii) no interest in such trust was acquired by purchase, and (iii) an election under ' 1361(e) applies to such trust.

Section 1361(e)(1)(B) provides that the term “electing small business trust@ shall not include (i) any qualified subchapter S trust (as defined in section 1361(d)(3)) if an election under ' 1361(d)(2) applies to any corporation the stock of which is held by such trust, (ii) any trust exempt from tax under subtitle A, and (iii) any charitable remainder annuity trust or charitable remainder unitrust (as defined in ' 664(d)).

Section 1361(e)(3) provides that an election under ' 1361(e) shall be made by the trustee. Any such election shall apply to the taxable year of the trust for which

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made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

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 section 1362(b)(2)) by reason of a failure to meet the requirements of section 1361(b) or to obtain shareholder consents, or (B) was terminated under paragraph (2) or (3) of section 1362(d); (2) the Secretary determines that the circumstances resulting in such ineffectiveness or termination was inadvertent, (3) no later than a reasonable period of time after discovery of the event resulting in such ineffectiveness or 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 section 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 the period, then, notwithstanding the circumstances resulting in the ineffectiveness or termination, the corporation shall be treated as continuing to be an S corporation during the period specified by the Secretary.

Based solely on the information submitted, and the representations made, we conclude that X's S corporation election was an inadvertent invalid election within the meaning of § 1362(f). Pursuant to the provisions of 1362(f), X will be treated as an S corporation effective D1 and thereafter, provided that X's election to be an S corporation was not otherwise invalid and not terminated under § 1362(d). Trust 1 will be treated as an ESBT under § 1361(e) and as a shareholder of X effective D1. Trust 2 will be treated as an ESBT under § 1361(e) and as a shareholder of X effective D2.

X's shareholders must include their pro rata share of the separately and nonseparately computed items of X as provided in § 1366, make any adjustments to stock basis as provided in § 1367, and take into account any distributions made by X to its shareholders as provided in 1368.

These rulings are conditioned upon Trust 1 and Trust 2 filing ESBT elections effective D1 and D2, respectively, with the appropriate Service Center within 60 days of the date of this letter. A copy of this letter should be attached to the ESBT elections. If X or X's shareholders fail to treat X as described above, this ruling will be null and void.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed whether X is otherwise eligible to be an S corporation, and whether Trust 1 and Trust 2 are otherwise eligible to be ESBTs.

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This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Internal Revenue Code 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 representatives.

Sincerely,

Beverly Katz
Senior Technician Reviewer, Branch 2
Associate Chief Counsel

(Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for ' 6110 purposes