PLR 200652012: Partnership stock holding receives S relief with distribution and ESBT elections

Plain-English summary

An S corporation's shares were transferred to a limited partnership owned by an individual and three trusts, making the partnership an ineligible shareholder. The corporation and owners continued reporting S income, and the IRS found the resulting termination inadvertent under section 1362(f). Relief treated the partners as direct shareholders during the termination period and required consistent income, basis, and distribution reporting. Within 60 days, the partnership had to distribute the shares to those partners and the trustees had to file ESBT elections effective from the original transfer date. The ruling did not establish the corporation's other S eligibility or the trusts' ESBT eligibility.

Ruling snapshot

• Question: Can the stock transfer to a partnership be remedied without interrupting S corporation treatment?
• Outcome: Approved, subject to distribution of shares and ESBT elections within 60 days and consistent direct-owner reporting.
• Key authorities: IRC §§ 1361(e), 1362(f), 1366, 1367 and 1368.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200652012
Third Party Communication: None
Release Date: 12/29/2006
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------ ----------------------, ID No. -------------
------------------------------------
Telephone Number:
----------------------------------------- ---------------------
--------------------
Refer Reply To:
CC:PSI:B02
PLR-117674-06
-
Date: August 30, 2006

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

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

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

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

LP = -----------------------------------------------------------------------------------------------------
------------------------

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

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

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

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

Trust
-----------------------------------------------------------------------------------------------------
3
------------------------

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

This letter responds to a letter dated March 7, 2006 submitted on behalf of X, requesting relief under § 1362(f) of the Internal Revenue Code.

PLR-117674-06
2

The information submitted states that X was incorporated and elected to be an S corporation effective D1. On D2, shares of X were transferred to LP, a State limited partnership. A, an individual, and three trusts: Trust 1, Trust 2, and Trust 3 (“Trusts”) have at all times been the sole partners of LP. It is represented that the Trusts are eligible to be electing small business trusts (“ESBTs”) described in § 1361(e). X was not aware that LP was an ineligible shareholder of an S corporation and that the transfer would terminate X’s S election. On D3, X’s tax return preparer discovered shares of X had been transferred to LP and that this transfer terminated X’s S election.

X represents that the termination of X’s S election was inadvertent and was not motivated by tax avoidance or retroactive tax planning. Further, since D2, X and X’s shareholders have continually treated X as an S corporation. As such, all items of income, gain, loss, and deduction recognized by X since D2 have been allocated among the shareholders of X, including LP. In turn, the partners of LP each reported, on their individual income tax returns for all taxable years since D2, their respective share of the income, gain, loss and deductions of X. X and its shareholders have agreed to make such adjustments as the Service may require with respect to all periods since D2.

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 1361(b)(1)(B) provides that a “small business corporation” means a domestic corporation that is not an ineligible corporation and that 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) provides that 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 a corporation is an S corporation) such corporation ceases to be a small business corporation. A termination of an S corporation election under § 1362(d)(2) is effective on and after the date of cessation.

Section 1362(f) provides that if (1) an election under § 1362(a) by any corporation was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in such termination were inadvertent, (3) no later than a reasonable period of time after discovery of the event resulting in the ineffectiveness, 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 § 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

PLR-117674-06
3

ineffectiveness, the corporation shall be treated as 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 election was terminated on D2 when shares of X were transferred to LP, an ineligible shareholder. We conclude, however, that this termination was inadvertent within the meaning of § 1362(f). Accordingly, pursuant to the provisions of § 1362(f), X will be treated as an S corporation effective D2 and thereafter.

During the termination period, A and the Trusts will be treated as if they held their shares in X directly. Accordingly, in determining their respective income tax liabilities during the termination period and thereafter, A and the Trusts must include their pro rata share of the separately 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, A, or the Trusts fail to treat themselves as described above, this ruling shall be null and void.

This ruling is contingent upon the distribution of X stock held by LP to A and the Trusts within sixty days from the date of this letter. In addition, this ruling is contingent upon the respective trustees of the Trusts filing an election to treat the Trusts as ESBTs effective D2 with the appropriate service center within sixty days from the date of this letter.

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the facts described above under any other provision of the Code. Specifically, no opinion is expressed on whether X was or otherwise eligible to be treated as an S corporation or whether the Trusts are eligible to be ESBTs.

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

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

Sincerely,

Bradford R. Poston
Senior Counsel, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)
Enclosures (2)
Copy of this letter
Copy for § 6110 purposes