PLR 200843002: Missed ESBT elections caused an inadvertent S termination

Plain-English summary

Two trusts received stock in an S corporation and represented that they qualified as electing small business trusts, but their trustee failed to make ESBT elections. That failure made the trusts ineligible shareholders and terminated the corporation’s S election. The corporation represented that the omission was not motivated by tax avoidance or retroactive planning and agreed with its shareholders to make any required adjustments. The IRS found the termination inadvertent and treated the corporation as continuously maintaining S status and the trusts as ESBTs from the stock-transfer date. Relief required ESBT elections and consistent amended returns from the trusts and their beneficiaries within 90 days.

Ruling snapshot

• Question: Could the corporation retain S status after its shareholder trusts missed their ESBT elections?
• Outcome: Approved. The termination was inadvertent, conditioned on elections and amended returns within 90 days.
• Key authorities: IRC §§ 671, 678, 1361, 1362(d), 1362(f), 1366, 1367, 1368; Treas. Reg. § 1.1361-1(m)(2)

Full text (IRS public release)

 Internal Revenue Service                                     Department of the Treasury
                                                              Washington, DC 20224

Number: 200843002                                            Third Party Communication: None
Release Date: 10/24/2008                                      Date of Communication: Not Applicable
                                                              Person To Contact:
Index Number: 1362.04-00                                      --------------------------, ID No. -------------
                                                              Telephone Number:
                                                              ---------------------
 ----------------------------------------                     Refer Reply To:
---------------------------------                             CC:PSI:B02
---------------------------------                             PLR-102284-08
 -------------------------------                              Date:
                                                              July 11, 2008




 X             = --------------------------------------------------------------------------------------------------
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 Grantors = --------------------------------------------------------------------------------------------------
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 Trust 1       = --------------------------------------------------------------------------------------------------
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 Trust 2       = --------------------------------------------------------------------------------------------------
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 Trust 3       = --------------------------------------------------------------------------------------------------
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 D1            = ----------------

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

 Year 1        = -------
PLR-102284-08                                 2


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

       This responds to a letter dated December 21, 2007, and subsequent
correspondence, submitted on behalf of X by its authorized representatives, requesting
a ruling under § 1362(f) of the Internal Revenue Code.

       The information submitted states that X made an election to be treated as an S
corporation effective D1. A and B created Trust 1 on D2 of Year 1 and funded it with X
stock. Pursuant to its terms, Trust 1 immediately divided into Trust 2 and Trust 3. Trust
2 and Trust 3 are represented as being eligible to be electing small business trusts
(ESBTs). The primary beneficiaries of Trust 2 and Trust 3 also have withdrawal powers
over their respective trusts that would cause them to be the owners of a portion of their
respective trusts under §§ 671 and 678. The trustee of Trust 2 and Trust 3 failed to
make ESBT elections. X’s S corporation election terminated effective D2 of Year 1.

       X represents that the failure to file the ESBT elections for Trust 2 and Trust 3 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) of the Code 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)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT may be a
shareholder of an S corporation.

       Section 1361(e) defines an ESBT. Section 1361(e)(1)(A) provides that, except
as provided in § 1362(e)(2)(B), an ESBT means 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 PCB, (ii) no
interest in such trust was acquired by purchase, and (iii) an election under § 1361(e)
applies to such trust. Section 1361(e)(3) provides that an election under § 1361(e) shall
be made by the trustee.

       Section 1.1361-1(m)(2)(i) of the Income Tax Regulations provides that the
trustee of an ESBT must make the ESBT election by signing and filing, with the service
PLR-102284-08                                3

center where the S corporation files its income tax return, a statement that meets the
requirements of § 1.1361-1(m)(2)(ii).

       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.

       Based solely on the facts submitted and the representations made, we conclude
that X’s S corporation election terminated on D2 of Year 1 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 D2 of
Year 1and thereafter, provided X’s S corporation election was valid and provided that
the election was not otherwise terminated under § 1361(d). Trust 2 and Trust 3 will be
treated as ESBTs from D2 of Year 1 and thereafter. 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.

       This ruling is conditioned upon the trustee of Trust 2 and Trust 3 filing
appropriately completed ESBT elections effective D2. The ESBT elections must be filed
within 90 days following the date of this letter and a copy of this letter should be
attached to the elections. It is additionally conditioned on Trust 2, Trust 3, and their
beneficiaries filing within 90 days following the date of this letter amended returns for
Year 1 and subsequent taxable years consistent with the treatment of Trust 2 and Trust
3 as ESBTs and the beneficiaries as the owners of their respective portions of Trust 2
and Trust 3 under §§ 671 and 678. A copy of this letter should be attached to each
PLR-102284-08                                 4

such amended return. If X or its shareholders fail to treat themselves as described
above, this ruling is null and void.

       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. In particular, we express no opinion on whether Trust 2 and Trust 3 are
otherwise eligible to be ESBTs.

      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, copies of this letter are being sent to X’s
authorized representatives.



                                       Sincerely,



                                       MELISSA C. LIQUERMAN
                                       Senior Technician Reviewer, Branch 2
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

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