PLR 200737040: Missed trust election does not end S corporation status

Plain-English summary

A shareholder transferred S corporation shares to a trust that initially qualified as a grantor trust. When that status ended, the trustee failed to elect treatment as an electing small business trust (ESBT), causing the corporation's S election to terminate. The IRS found the termination inadvertent under section 1362(f). It allowed the corporation to continue as an S corporation from the termination date if the trustee filed a proper ESBT election within 60 days and the corporation and trust otherwise remained eligible. The shareholders must report income, basis changes, and distributions consistently with S corporation treatment; failure to do so voids the ruling.

Ruling snapshot

• Question: Could the corporation retain S status after its shareholder trust missed the ESBT election?
• Outcome: Approved, subject to a proper ESBT election within 60 days and consistent tax reporting.
• Key authorities: IRC §§ 1361(c), 1361(e), 1362(f), 1366-1368; Treas. Reg. §§ 1.1361-1(m), 1.1362-4.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200737040
Third Party Communication: None
Release Date: 9/14/2007
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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Refer Reply To:
----------------------------------------- CC:PSI:B02 PLR-156938-06
Date:
June 06, 2007

X = -----------------------------------------------------------------------------------------------------
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A = -----------------------------------------------------------------------------------------------------
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Trust = -----------------------------------------------------------------------------------------------------
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State1 = -------------

D1 = ----------------------
D2 = ---------------------------
D3 = ----------------------

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

This responds to a letter dated December 6, 2006, and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue Code.

The information submitted states that X is a State1 corporation that made an election to be treated as an S corporation effective D1. A, a shareholder of X, created Trust on D2. A contributed and sold shares of X to Trust on D2. Trust is represented as being a grantor trust from D2 until D3, and being eligible to be an electing small business trust (ESBT) as of D3. However, the trustee of Trust failed to make a valid ESBT election effective D3. Consequently, X’s S corporation election terminated on D3.
PLR-156938-06
2

X represents that the failure to file the ESBT election for Trust was not motivated by tax avoidance or retroactive tax planning. X and its shareholders have agreed to make any adjustments that the Commissioner may require, consistent with the treatment of X as 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)(A)(i) provides that, for purposes of § 1361(b)(1)(B), a trust all of which is treated (under subpart E of part I of subchapter J of chapter 1) as owned by an individual who is a citizen or resident of the United States may be a shareholder.

Section 1361(c)(2)(A)(v) provides that for the purposes of § 1361(b)(1)(B), an ESBT may be a shareholder in an S corporation.

Section 1361(e)(1)(A) provides that an ESBT is any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in § 170(c)(2), (3), (4) or (5) or (IV) an organization described in § 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary; (ii) no interest in such trust was acquired by purchase; and (iii) an election under § 1361(e) applies to such trust.

Section 1.1361-1(m)(2)(i) of the Income Tax Regulations provides that the trustee must make the ESBT election by signing and filing, with the service center where the S corporation files its income tax return, a statement meeting the requirements of § 1.1361-1(m)(2)(ii). Section 1.1361-1(m)(2)(ii) provides that the election statement must include (A) the name, address and taxpayer identification number of the trust, the potential current beneficiaries, and the S corporation in which the trust currently owns stock; (B) an identification of the election as an ESBT election made under § 1361(e)(3); (C) the first date on which the trust owned stock in each S corporation; (D) the date on which the election is to become effective (not earlier than 15 days and two months before the date on which the election is filed) and (E) representations signed by the trustee stating that the trust meets the requirements of § 1361(e)(1) and all potential current beneficiaries of the trust meet the shareholder requirements of § 1361(b)(1).
PLR-156938-06
3

Section 1.1361-1(m)(3)(i) provides that if a trust makes a valid ESBT election, the trust will be treated as an ESBT for purposes of chapter 1 of the Internal Revenue Code as of the effective date of the ESBT election.

Section 1362(d)(2) provides that (A) in general, 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 the corporation is an S corporation) such corporation ceases to be a small business corporation and (B) any termination under § 1362(d)(2) 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 the ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in the ineffectiveness or termination, steps were taken (A) so that the corporation is a small business corporation or (B) to acquire the 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 the ineffectiveness or termination, the corporation will be treated as an S corporation during the period specified by the Secretary.

Section 1.1362-4(b) provides that the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the event took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event, tends to establish that the termination was inadvertent.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the Commissioner. In the case of a transfer of stock to an ineligible shareholder that causes an inadvertent termination under § 1362(f), the Commissioner may require that ineligible shareholder to be treated as a shareholder of an S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the Commissioner may require protective adjustments that prevent any loss of revenue due to a transfer of stock to an ineligible shareholder.
PLR-156938-06
4

Based solely on the facts submitted and the representations made, we conclude that X’s S corporation election terminated on D3 because of the failure to file an ESBT election for Trust, and that the termination was inadvertent within the meaning of § 1362(f). We further hold that, pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation from D3, and thereafter, provided X’s S corporation election was valid and provided that the election was not otherwise terminated under § 1361(d). Trust will be treated as an ESBT from D3, provided that Trust is otherwise eligible to be an ESBT, until its ESBT status terminates. 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 themselves as described above, this ruling is null and void.

This ruling is conditioned upon the trustee of Trust filing a properly completed ESBT election effective D3, with the appropriate service center within 60 days following the date of this letter. A copy of this letter should be attached to the ESBT election.

Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provisions of the Code.

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

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

Sincerely,

James A. Quinn
Senior Technician Reviewer (Acting), Branch 2 Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes