PLR 200621008: Trust election and income errors receive inadvertent S termination relief

Plain-English summary

An S corporation's election ended after successor shareholder trusts failed to make qualified subchapter S trust elections. Another shareholder trust also failed to distribute all its income to its beneficiary in two years, which would have caused a later termination. The IRS found the termination inadvertent and ruled that S corporation treatment could continue from the first error onward. Relief requires the successor trusts to file their elections and affected parties to file consistent amended returns within 60 days. If the corporation or shareholders do not follow the specified treatment, the ruling is void.

Ruling snapshot

• Question: Could the corporation retain S status despite missing trust elections and income distributions?
• Outcome: Approved, conditioned on trust elections and amended returns within 60 days.
• Key authorities: IRC §§ 1361(d), 1362(f), 1366–1368.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200621008
Third Party Communication: None
Release Date: 5/26/2006
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
---------------------------------------
-------------------------, ID No. ------------
-------------------------------------------
Telephone Number:
--------------------------------------------- --------------------
------------------------------------
Refer Reply To:
CC:PSI:B02
PLR-146983-05
-
Date:
January 31, 2006

X = -----------------------------------------------------------------------------------------------------
----------------------

Trust = -----------------------------------------------------------------------------------------------------
1
-----------------------

Trust = -----------------------------------------------------------------------------------------------------
2
-----------------------

Trust = -----------------------------------------------------------------------------------------------------
3
-----------------------

Trust = -----------------------------------------------------------------------------------------------------
4
-----------------------

Trust = -----------------------------------------------------------------------------------------------------
5
-----------------------

A = -----------------------------------------------------------------------------------------------------
-------------------------

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

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

Year = -------
1

Year = -------
2
Year = -------
3

PLR-146983-05
2

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

This responds to a letter dated September 8, 2005, and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue Code.

X made an election to be treated as an S corporation effective D1. Trust 1, a shareholder of X, is represented as having been an electing small business trust (ESBT) under § 1361(e). Trust 1 was divided into Trust 2, Trust 3, and Trust 4 (collectively, the Successor Trusts) and the stock held by Trust 1 was distributed to the Successor Trusts on D2. Each of the Successor Trusts is represented as being eligible to be a qualified subchapter S trust (QSST). However, the beneficiaries of the Successor Trusts failed to make QSST elections.

Trust 5 is an X shareholder, for which A, its beneficiary, made an election to be treated as a QSST effective D1. Trust 5 failed to distribute all of its income (within the meaning of § 643(b)) to A for the Year 1 or Year 2 taxable years. In Year 3, Trust 5 distributed all of the income to A which it should have distributed in Year 1 and Year 2.

X’s S corporation election terminated on D2 when the Successor Trusts became shareholders. X’s S corporation election would also have terminated (if it had not already terminated on D2) on the first day of Year 2 because of Trust 5’s failure to distribute all of its income to A.

X represents that the failure to file the QSST elections for the Successor Trusts and the failure of Trust 5 to distribute all of its income were not motivated by tax avoidance or retroactive tax planning. 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.

Section 1361(a)(1) of the Code 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 the term "small business corporation" means a domestic corporation which is not an ineligible corporation and which 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 1361(c)(2)(A)(i) provides that, for purposes of ' 1361(b)(1)(B), a trust all of which is treated (under subpart E of part I of subchapter J of chapter 1) as owned by an individual who is a citizen or resident of the United States may be a shareholder.

PLR-146983-05
3

Section 1361(d)(1) provides that in the case of a QSST for which a beneficiary makes an election under ' 1361(d)(2), the trust is treated as a trust described in ' 1361(c)(2)(A)(i), and for purposes of ' 678(a), the beneficiary of the trust shall be treated as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the election under ' 1361(d)(2) is made. Section 1361(d)(2)(A) provides that a beneficiary of a QSST may elect to have § 1361(d)(1) apply.

Section 1361(d)(3)(B) provides that for purposes of § 1361(d), the term “qualified subchapter S trust” means a trust all of the income (within the meaning of § 643(b)) of which is distributed currently to one individual who is a citizen or resident of the United States.

Section 1361(d)(4) provides that if any QSST ceases to meet any requirement of
§ 1361(d)(3)(B) but continues to meet the requirements of § 1361(d)(3)(A) (regarding the terms of the trust), the provisions of § 1361(d) shall not apply to such trust as of the first day of the first taxable year beginning after the first taxable year for which it failed to meet the requirements of § 1361(d)(3)(B).

Section 1.1361-1(j)(6)(ii) of the Income Tax Regulations provides that the current income beneficiary of a QSST must make the election under ' 1361(d)(2) by signing and filing with the service center with which the corporation files its income tax returns the applicable form or a statement including the information listed in ' 1.1361-1(j)(6)(ii).

Section 1362(d)(2) provides that (A) in general, an election under § 1362(a) 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 and (B) any termination under § 1362(d)(2) shall be effective on and after the date of cessation.

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 consents or (B) was terminated under ' 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in the ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in the ineffectiveness or termination, steps were taken (A) so that the corporation is a small business corporation or (B) to acquire the 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 ' 1362(f), 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 the ineffectiveness or termination, the corporation will be treated as an S corporation during the period specified by the Secretary.

PLR-146983-05
4

Based solely on the facts submitted and the representations made, we conclude that the termination of X’s S corporation was inadvertent within the meaning of
§ 1362(f). We further hold that, pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation from D2 and thereafter, provided X’s S corporation election was valid and provided that the election was not otherwise terminated under
§ 1361(d). The Successor Trusts and Trust 5 will be treated as QSSTs from D2 and thereafter. The shareholders of X must include their pro-rata share of the separately stated and nonseparately computed items of X as provided in § 1366, make any adjustments to basis as provided in § 1367, and take into account any distributions made by X as provided in § 1368. If X or its shareholders fail to treat themselves as described above, this ruling is null and void.

This ruling is conditioned upon (1) the beneficiaries of the Successor Trusts filing appropriately completed QSST elections for the Successor Trusts effective D2 and (2) X, A, the Successor Trusts, Trust 5, and any other affected shareholders of X filing any amended returns necessary to conform to this letter. Specifically, Trust 5 and A must file amended returns consistent with the treatment of Trust 5 as a QSST and A as the deemed owner of the portion of Trust 5 consisting of X stock for Year 1 and all subsequent years. The QSST elections and any amended returns must be filed within 60 days following the date of this letter and a copy of this letter should be attached to any such elections or returns.

Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provisions of the Code. In particular, we express no opinion on whether the Successor Trusts or Trust 5 are otherwise eligible to be QSSTs.

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

Pursuant to a power of attorney on file, a copy of this letter is being sent to X’s authorized representative.

Sincerely,

J. THOMAS HINES
Chief, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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