PLR 200745013: S status preserved after stock issued to ineligible shareholder

Plain-English summary

An S corporation issued stock to a nonresident alien, who could not be an S corporation shareholder. That issuance terminated its S election, but the corporation later rescinded the agreement and cancelled the shares. The IRS found the termination inadvertent and allowed the corporation to continue being treated as an S corporation from its original election date, assuming its election was otherwise valid. The IRS did not decide whether a separate agreement created a prohibited second class of stock.

Ruling snapshot

• Question: Could S status continue after an inadvertent stock issuance to a nonresident alien?
• Outcome: Yes, if the S election was otherwise valid and not separately terminated.
• Key authorities: IRC §§ 1361(b)(1), 1362(f); Treas. Reg. § 1.1362-4.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200745013
Third Party Communication: None
Release Date: 11/9/2007
Date of Communication: Not Applicable

Person To Contact:
Index Number: 1362.00-00, 1362.04-00
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Telephone Number:
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Refer Reply To:
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CC:PSI:B03
----------------------------------------- PLR-125090-07 Date:
August 09, 2007

Legend

X = ---------------------------------------------------------------------------------------
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A = ---------------------------------------------------------------------------------------
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B = ---------------------------------------------------------------------------------------
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C = ---------------------------------------------------------------------------------------
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a = ------

Agreement 1 = ---------------------------------------------------------------------------------------
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Agreement 2 = ---------------------------------------------------------------------------------------
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State = -------------

Date1 = -------------------------

Date2 = ------------------

Date3 = -------------------
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Dear -----------:

We received the letter dated May 29, 2007, submitted on behalf of X by X’s authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue Code. This letter responds to that request.

Facts

X incorporated under State law on Date1. X elected to be treated as a subchapter S corporation effective Date1. On Date2, X issued a shares of stock under Agreement 1 to C, a nonresident alien, and thus an ineligible S corporation shareholder under § 1361(b)(1)(C). X’s S corporation election therefore terminated on Date2. On Date3, X rescinded Agreement 1 and cancelled the shares issued to C.

X represents that X and its shareholders, A and B, have at all times intended X to be an S corporation since its election effective Date1. X further represents that X and its shareholders have treated themselves consistent with S corporation status. X also represents that the circumstances resulting in the termination of X’s S corporation election were inadvertent and were not motivated by tax avoidance or retroactive tax planning. X and its shareholders agree to make such adjustments consistent with the treatment of X as an S corporation as may be required by the Secretary under § 1362(f).

Law

Section 1361(a) 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) provides that the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 100 shareholders, (B) 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, (C) have a nonresident alien as a shareholder, and (D) have more than 1 class of stock.

Section 1362(a)(1) provides, in general, 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 1362(d)(2)(A) provides that an election under § 1362(a) shall be terminated whenever (at any time on or after the 1st day of the 1st taxable year for which
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the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(f) provides that if (1) an election under § 1362(a), 1361(b)(3)(B)(ii), or § 1361(c)(1)(A)(ii) 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 § 1362(d)(3), § 1361(b)(3)(C), or § 1361(c)(1)(D)(iii), (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 for which the election was made or the termination occurred is a small business corporation or a qualified subchapter S subsidiary, as the case may be, or (B) to acquire the required shareholder consents, and (4) the corporation for which the election was made or the termination occurred, and each person who was a shareholder in such corporation at any time during the period specified pursuant to this subsection, agrees to make such adjustments (consistent with the treatment of such corporation as an S corporation or a qualified subchapter S subsidiary, as the case may be) 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 or a qualified subchapter S subsidiary, as the case may be during the period specified by the Secretary.

Section 1.1362-4(b) of the Income Tax Regulations provides that, for purposes of § 1.1362-4(a), 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.

Conclusion

Based on the facts submitted and representations made, we conclude that X’s S corporation election terminated on Date2 when X issued a shares of stock under Agreement 1 to C, a nonresident alien, and thus an ineligible S corporation shareholder
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under § 1361(b)(1)(C). We also conclude that the termination was inadvertent within the meaning of § 1362(f). Consequently, we conclude that X will continue to be treated as an S corporation from Date1 and thereafter, provided that X’s S corporation election was valid and was not, except for the event described on Date2, otherwise terminated.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed or implied as to whether X otherwise qualifies as a subchapter S corporation under § 1361. In addition, no opinion is expressed or implied as to whether Agreement 2 created a second class of stock for purposes of § 1361(b)(1)(D).

Under a power of attorney on file with this office, we are sending a copy of this letter to your 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.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

/s/

Leslie H. Finlow
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures (2)
A copy of this letter
A copy for § 6110 purposes

cc: