PLR 200748004: Invalid S election treated as effective after corporate shareholder removed

Plain-English summary

A corporation elected S status while another corporation held its stock, making the election invalid from the intended start date. After discovering that a corporate shareholder was ineligible, the shareholder distributed the stock to individuals. The IRS found the invalid election inadvertent and treated the company as an S corporation from the original effective date under section 1362(f). That treatment depended on the election otherwise being valid and on the corporation and all shareholders reporting consistently with S status.

Ruling snapshot

• Question: Could an S election be treated as effective despite an ineligible corporate shareholder at its start?
• Outcome: Yes, after the corrective stock distribution and subject to consistent S corporation treatment.
• Key authorities: IRC §§ 1361(b)(1)(B) and 1362(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200748004
Third Party Communication: None
Release Date: 11/30/2007
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------ -----------, ID No. -------------
--------------------------------------------- Telephone Number:
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Refer Reply To:
CC:PSI:B01
PLR-118185-07
Date: August 27, 2007

Legend:

X = ------------------------------------------
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State = ------------

D = -----------------

Y = ---------------------------------------------------------------
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Dear -------------:

This responds to the letter dated March 14, 2007, and related correspondence, submitted on behalf of X, requesting relief under ' 1362(f) of the Internal Revenue Code (ACode@) for an inadvertent invalid S election.

FACTS

The information submitted states that X was incorporated under the laws of State. In addition, X elected to be treated as an S corporation effective D. At the time of the election, X had a corporate shareholder, Y.

X and its shareholders represent that they were unaware of the fact that Y is an ineligible shareholder and did not intend the S election to be ineffective. Immediately after the discovery of the error, they took remedial action by having Y distribute its X

PLR-118185-07
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stock to its individual shareholders so that the shareholders of X were again eligible shareholders.

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 1361(b)(1)(B) provides that a small business corporation cannot 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)(A) 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 the corporation is an S corporation) the corporation ceases to be a small business corporation.

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.

CONCLUSION

Based solely upon the facts submitted and the representations made, we conclude that, as of D, X did not meet the requirements of § 1361(b)(1)(B). Therefore, X’s S election was ineffective for the taxable year beginning D. We further conclude that the ineffectiveness of X’s S election constituted an inadvertent invalid S election within the meaning of § 1362(f).

Under § 1362(f), X will be treated as an S corporation from D, and thereafter, provided that X’s S election was otherwise valid and has not otherwise terminated under § 1362(d).

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This ruling is contingent upon X and all its shareholders treating X as having been an S corporation for the period beginning D, and thereafter.

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, copies of this letter ruling will be sent to your authorized representative.

Sincerely,

David R. Haglund
Senior Technician Reviewer
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)

Copy of this letter
Copy for ' 6110 purposes