PLR 200712016: S corporation status restored after stock went to ineligible partnership

Plain-English summary

An S corporation issued shares to a limited partnership, which could not be an eligible S corporation shareholder. That issuance terminated its S election. After tax advisors identified the problem, the partnership distributed the shares to an individual. The IRS found the termination inadvertent and allowed the corporation to continue being treated as an S corporation from the date of the stock issuance onward. The ruling requires the corporation and shareholders to report consistently with that treatment and treats the individual as owning the shares during the affected period. The IRS did not decide whether the original S election was valid or whether the corporation otherwise qualified as an S corporation.

Ruling snapshot

• Question: Can an S corporation retain its tax status after inadvertently issuing stock to an ineligible partnership?
• Outcome: Approved, subject to consistent tax reporting and the validity of its original S election.
• Key authorities: IRC §§ 1361, 1362(f), 1366–1368.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200712016
Release Date: 3/23/2007
Index Number: 1362.04-00

Person To Contact:
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ID No. -------------
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Telephone Number:
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Refer Reply To:
CC:PSI:2 – PLR-131110-06
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Date: November 17, 2006

X = ---------------------------------------------------------------------------------------------------
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A = -----------------------------------------------
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B = ----------------------------
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State = --------
D1 = ----------------------
D2 = ----------------------
D3 = ----------------------
D4 = ---------------------
D5 = ------------------
z = -------

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

This letter responds to a letter dated June 13, 2006, submitted by X's authorized representative on behalf of X, requesting inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

The information submitted states that X was incorporated under the laws of State on D1 and elected to be an S corporation effective D2. On D3, X issued z shares of X stock to A, a State limited partnership. On D4, X's tax advisors notified X that its issuance of stock to A caused the termination of X’s S corporation election. To remedy this problem, on D5, A distributed all of its shares of X stock to B, an individual and an eligible S corporation shareholder.

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

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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 1361(a)(1) defines an S corporation as a "small business corporation" for which an election under § 1362(a) is in effect for such year.

Section 1361(b)(1)(B) provides that a "small business corporation" cannot have as a shareholder a person (other than an estate and other than 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 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 paragraph (2) or (3) of § 1362(d), (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 circumstances resulting in such termination, steps were taken so that the corporation is a small business corporation, 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 termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Based solely on the facts represented, we conclude that X's S corporation election was terminated on D3 when A, an ineligible shareholder, acquired X stock. We also conclude that this termination was inadvertent within the meaning of § 1362(f).

Therefore, we conclude that X will continue to be treated as an S corporation for the period from D3 and thereafter, provided that X’s S corporation election was valid and provided that the election was not otherwise terminated under § 1362(d). During the period from D3 and thereafter, B will be treated as the owner of the X stock acquired by A. 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 X as described above, this letter ruling will be null and void.

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Except as specifically ruled above, we express no opinion concerning the federal income tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed regarding X's eligibility to be an S corporation or the validity of its S corporation election.

In accordance with the power of attorney on file with this office, we are sending a copy of this letter to X’s authorized representative.

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

Sincerely,

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

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