PLR 200633018: Ineligible trust owners receive inadvertent S termination relief

Plain-English summary

An S corporation issued shares to two trusts that were not eligible S corporation shareholders. After learning of the problem, it reissued the shares to the trusts' individual beneficiaries. The IRS ruled that the stock issuance had terminated the S election, but that the termination was inadvertent under IRC § 1362(f). The corporation could be treated as continuing its S status through the correction period if its original election was valid and there was no other termination. Shareholders had to report S corporation items, basis changes, and distributions consistently; the IRS did not decide whether the corporation otherwise qualified for S status.

Ruling snapshot

• Question: Could the corporation retain S treatment while ineligible trusts held its shares?
• Outcome: Approved as inadvertent termination relief, subject to the ruling's conditions.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(d)(2), 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200633018
Third Party Communication: None
Release Date: 8/18/2006
Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.03-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B02
PLR-142942-05
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Date:
May 16, 2006

Legend

X: -------------------------------------------------------------
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Trust 1: ------------------------
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Trust 2: ----------------------
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Date 1: ----------------------

Date 2: -----------------------

Date 3: --------------------

Date 4: -----------------

Date 5: -------------------

Dear ----- -------------:
PLR-142942-05
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This responds to a letter dated July 26, 2005, and subsequent correspondence submitted on behalf of X, requesting a ruling under § 1362(f) of the Internal Revenue Code.

Facts

The information submitted states that X was incorporated on Date 1 and elected to be an S corporation effective the date of incorporation. On Date 2, X shares were issued to Trust 1 and Trust 2 (collectively the Trusts). The Trusts, however, were ineligible shareholders and, therefore, X’s election to be an S corporation was inadvertently terminated on Date 2. On Date 3, X was advised by its tax advisers that the Trusts were ineligible shareholders. On Date 4 and Date 5, the shares of X held by the Trusts were reissued to the individual beneficiaries of the Trusts.

X represents that the circumstances resulting in the termination of X’s election to be an S corporation were inadvertent. X represents that since Date 1, X and its shareholders have filed federal income tax returns consistent with X’s S corporation election. Furthermore, the beneficiaries of the Trusts represent that they have reported all of the income from the Trusts on their individual federal income tax returns. X and each person who is or was a shareholder of X at anytime since Date 1, agree to make such adjustments, consistent with the treatment of X as an S corporation, that the Secretary may require.

Law and Analysis

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 1361(c)(2) provides that certain trusts are permitted as shareholders.
Section 1361(c)(2)(A) provides, in part, that § 1361(c)(2) shall not apply to any foreign trust.
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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.

Conclusion

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 its stock to ineligible shareholders, and that this termination of X's S election was inadvertent 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 through Date 5, 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.

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.
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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,

Beverly Katz
Senior Technician Reviewer, Branch 2
Associate Chief Counsel
(Passthroughs and Special Industries)

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

cc: