PLR 200621009: S corporation status continues after inadvertent shareholder error

Plain-English summary

An S corporation issued shares to a nonresident alien, an ineligible shareholder, causing its S election to terminate. The IRS accepted the company's representation that the error was inadvertent and was not tax planning. Under IRC § 1362(f), it ruled that the company would continue to be treated as an S corporation through the later sale of all its shares, provided its original election was valid and no other termination occurred. The shareholders must report and adjust their taxes consistently with S corporation treatment; failure to do so makes the ruling void.

Ruling snapshot

• Question: Could the company retain S corporation treatment after issuing shares to an ineligible owner?
• Outcome: Approved, subject to consistent tax treatment by the company and shareholders.
• Key authorities: IRC §§ 1361, 1362(f), 1366–1368.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200621009
Release Date: 5/26/2006
Index Numbers: 1362.04-00

• Person To Contact:
  -------------------------------------- ------------------------ ----------------------
  ------------------------------------------ Telephone Number:
  --------------------- --------------------
  --------------------------- Refer Reply To:
  CC:PSI:2 – PLR-150050-05
  Date:
  February 07, 2006

Legend

X: --------------------------------------------
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Y: --------------------

A
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State: ------------

a: -------

b: -------

Date 1: ---------------------
Date 2: -----------------------
Date 3: --------------------------------
Date 4: -----------------------

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

This responds to a letter dated September 29, 2005, and additional correspondence submitted on behalf of X by its authorized representative, requesting relief pursuant to § 1362(f) of the Internal Revenue Code. The information submitted states that X was incorporated under the laws of State and elected to be treated as an S corporation on Date 1. On Date 2 and Date 3, X

PLR-150050-05
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issued a and b shares of X stock to A. A, a nonresident alien, is an ineligible shareholder. Therefore, X's S election terminated on Date 2. On Date 4, all of X’s stock was sold to Y.

X represents that the circumstances resulting in the termination of X's S corporation election were inadvertent and were not motivated by tax avoidance or retroactive tax planning. X and its shareholders have agreed to make such adjustments (consistent with the treatment of X as an S corporation) as may be required by the Secretary.

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 "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 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 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 such ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances 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 in 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 such ineffectiveness or termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.

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Based solely on the representations made and the information submitted, we conclude that X's S corporation election terminated on Date 2, under § 1362(d)(2), when X issued X stock to A, an ineligible shareholder, and that this termination of X's S 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 from Date 2 and Date 3 and through Date 4, provided X's S corporation election was valid and was not otherwise terminated under § 1362(d). All of X's shareholders in determining their respective income tax liabilities during the termination period and thereafter, must include their pro rata share of the separately stated items of income (including tax-exempt income), loss, deduction, or credit and non-separately stated computed items of income or loss of X as provided in § 1366, make any adjustments to basis provided in § 1367, and take into account any distributions made by X as provided in § 1368.

Additionally, during the termination period and thereafter, A will be treated as the owner of a and b shares of X stock from Date 2 and Date 3 respectively through Date 4. If A, X, or X's shareholders fail to treat X as described above, this ruling shall be null and void.

Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provision of the Code. Specifically, no opinion is expressed on whether X is otherwise eligible to be treated as an S corporation.

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

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

Sincerely,

J. Thomas Hines
Chief, Branch 2
Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes
cc: