PLR 200651024: Passive-income S termination relief requires payment within 30 days

Plain-English summary

An S corporation acquired C corporation earnings and profits in a merger and later sold its assets on installments. Passive investment income exceeded 25 percent of gross receipts for three consecutive years while the accumulated earnings remained. An accountant discovered the resulting S termination, and the corporation distributed all accumulated earnings and elected to distribute them first. The IRS found the termination inadvertent under section 1362(f) and allowed continued S status from the termination date. Relief requires payment of a redacted adjustment amount, with a copy of the ruling, within 30 days of the letter. Failure to meet the conditions voids the ruling and requires notification that the S election terminated.

Ruling snapshot

• Question: May S status continue after accumulated C corporation earnings and three years of excessive passive income cause termination?
• Outcome: Approved, conditioned on the specified adjustment payment within 30 days.
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1368(e)(3), 1375; Treas. Reg. § 1.1368-1(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200651024
Third Party Communication: None
Release Date: 12/22/2006
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------
-----------, ID No. -------------
---------------------------------------------
Telephone Number:
------------------------
(202) 622-3050
---------------------
Refer Reply To:
-----------------------------
CC:PSI:B01
PLR-146077-05
Date: September 1, 2006

Legend:

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

State = ------------

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

Year 1 = -------

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

Y = ----------------------------.
------------------------

a = ---------------

Z = ------------------------------
------------------------

Year 2 = -------

Year 3 = -------

PLR-146077-05
2

Year 4 = -------

Year 5 = -------

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

n = --------------

Dear -----------------

This responds to the letter dated September 1, 2005, and related correspondence, submitted on behalf of X, requesting relief under ' 1362(f) of the Internal Revenue Code (ACode@) for an inadvertent termination of S election.

FACTS

The information submitted states that X was incorporated under the laws of State, and elected to be treated as an S corporation for federal tax purposes, effective D1. In Year 1, Y, a C corporation with $a of accumulated earnings and profits (“CE&P”), merged into X in a reorganization under § 368(a)(1)(A). As a result, X acquired the CE&P under § 381(c)(2). On D2, X sold its assets to Z. X used the installment sale method to report income from the sale of its assets. For each of the consecutive years of Year 2, Year 3, and Year 4, X had passive investment income from the installment sale exceeded 25 percent of its yearly gross receipts.

In Year 5, after receiving the last payment on the sale, the accountant of X discovered the CE&P, which were erroneously recorded, and determined that the S election of X terminated on D3. To correct the error, X distributed the entire amount of the CE&P in Year 5 and elected to distribute the CE&P first for Year 5 pursuant to § 1.1368-1(f) of the Income Tax Regulations.

LAW AND ANALYSIS

Section 1361(a)(1) defines an “S corporation” as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close of each of three consecutive taxable years, and has gross receipts for each of the taxable years more than 25 percent of which are passive investment income. The termination is effective on and after the first date of the first taxable year beginning after the third consecutive taxable year referred to in § 1362(d)(3)(A)(i). § 1362(d)(3)(A)(ii).

PLR-146077-05
3

Except as otherwise provided in § 1362(d)(3)(C), § 1362(d)(3)(C)(i) provides that the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.

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 consent, 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 the 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 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 termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1368(c) provides rules for determining the source of distributions made by an S corporation having accumulated earnings and profits with respect to its stock. Section 1368(e)(3) and § 1.1368-1(f)(2) provide that an S corporation may, with the consent of all its affected shareholders, elect to distribute earnings and profits first.

Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or part of its accumulated earnings and profits through a deemed dividend. If an S corporation makes the election provided in § 1.1368-1(f)(3), the S corporation will be considered to have made the election under § 1368(e)(3) and § 1.1368-1(f)(2) to distribute earnings and profits first.

Section 1375 imposes a tax on the income of an S corporation that has accumulated earnings and profits at the close of a taxable year, and that has gross receipts more than 25 percent of which are passive investment income (within the meaning of § 1362(d)(3)).

CONCLUSION

Based solely upon the representations made and the information submitted, we conclude that X’s S election terminated on D3.

We further conclude that the termination of X’s S election was an inadvertent termination within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation on and after D3, unless X’s S election is otherwise terminated under § 1362(d), and provided that the following

PLR-146077-05
4

conditions are met. As an adjustment under § 1362(f)(4), X must send a payment of $n with a copy of this letter to the following address:

Internal Revenue Service
Cincinnati Service Center
Attn: Accounting Branch, Stop 21
201 West Rivercenter Blvd.
Covington, KY 41019

X must send this payment no later than 30 days from the date of this letter.

If all of the above conditions are not met, then this ruling is null and void.
Furthermore, if these conditions are not met, X must notify Cincinnati Service Center that its S election has terminated.

Except as specifically ruled upon above, no opinion is expressed as to the federal income tax consequences of the facts described above under any other provision of the code.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the 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 ruling will be sent to your authorized representative.

Sincerely,

Dianna K. Miosi
Chief, Branch 1
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)

Copy of this letter
Copy for ' 6110 purposes