PLR 200843007: Trust ownership caused an inadvertent S corporation termination

Plain-English summary

An S corporation’s stock was held by a grantor trust. After the deemed owner died, the trust remained an eligible shareholder for two years but then became ineligible and terminated the S election. The trust later transferred shares to another trust and four subtrusts intended to qualify as qualified subchapter S trusts, but beneficiaries of the subtrusts did not make the required QSST elections. The corporation represented that everyone had consistently reported as though S status continued and that the failures were inadvertent rather than tax-motivated. The IRS treated the corporation as continuing to be an S corporation, contingent on the remaining beneficiary filing a QSST election effective from the transfer date within 60 days and on consistent shareholder tax treatment.

Ruling snapshot

• Question: Could the corporation retain S status after a post-death trust became ineligible and QSST elections were missed?
• Outcome: Approved. The termination was inadvertent, with relief conditioned on a timely QSST election and consistent reporting.
• Key authorities: IRC §§ 1361(c), 1361(d), 1362(d), 1362(f), 1366, 1367, 1368; Treas. Reg. § 1.1361-1(h), (j)

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

Number: 200843007                                               Person To Contact:
Release Date: 10/24/2008                                        --------------------, ID No. -------------
                                                                Telephone Number:
Index Number: 1362.04-00                                        ---------------------
                                                                Refer Reply To:
 -------------------------------------                          CC:PSI:B01
----------------------------------                              PLR-104706-08
                                                                Date:
------------------------------------                            July 24, 2008
 -----------------------------




 Legend

 X                 =         --------------------------------------
 ---------------------------------------------------

 A                 =         -------------------------------
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 B                 =         ---------------------------
 -----------------------------------------------------

 State             =        ------

 Trust 1           =         -----------------------------------------------------------
                            ---------------------------
 ---------------------------------------------------

 Trust 2           =         -----------------------------------------------------------------------------------------
 --------------------------------------------------------------------------------------------------------
 ---------------------------------------------------

 Trust 3           =         -----------------------------------------------------------------------------------------
 --------------------------------------------------------------------------------------------------------
 ---------------------------------------------------

 Trust 3A          =         --------------------------------------------------------------------------
 -----------------------------------------------------
 ---------------------------------------------------
PLR-104706-08                                             2



Trust 3B          =         --------------------------------------------------------------------------
---------------------------------------------------------------
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Trust 3C          =         --------------------------------------------------------------------------
-------------------------------------------------------
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Trust 3D          =         --------------------------------------------------------------------------
------------------------------------------------
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Date 1            =        --------------------------

Date 2            =        ----------------------

Date 3            =        ---------------------------

Date 4            =        -----------------------

Date 5            =        ------------------------

Date 6            =        -----------------------

Date 7            =        -------------------

Year 1            =        -------

Year 2            =        -------


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

       This responds to a letter dated January 28, 2008, and subsequent
correspondence, submitted on behalf of X, requesting a ruling under § 1362(f) of the
Internal Revenue Code.

Facts

       The information submitted states that X was incorporated under the laws of State
on Date 1 and elected to be treated as an S corporation effective Date 2. On Date 3, A
transferred all of the stock of X to Trust 1, a grantor trust that was treated (under
subpart E of part 1 of subchapter J of chapter 1) as entirely owned by A.
PLR-104706-08                                3


       On Date 4, A died and Trust 1 ceased to be a grantor trust. Nevertheless,
Trust 1 continued to qualify as a permissible S corporation shareholder under
§ 1361(c)(2)(A)(ii) for the 2-year period beginning on the day of the deemed owner’s
death and ending on Date 5. Trust 1’s trust agreement provided that, upon A’s death,
the X stock held by Trust 1 shall be transferred to Trust 2 and Trust 3. Trust 1’s trust
agreement further provided that Trust 3 consists of four subtrusts, Trust 3A, Trust 3B,
Trust 3C, and Trust 3D.

      On Date 5, Trust 1 became an ineligible shareholder of X and X’s election to be
an S corporation terminated.

        On Date 6, after the 2-year period described in § 1361(c)(2)(A)(ii) had expired,
Trust 1 transferred X stock to Trust 2 and to the four subtrusts of Trust 3. But for the
termination of X’s S corporation election on Date 5, Trust 2 would have qualified as a
qualified subchapter S trust (QSST) under § 1361(d)(1) on Date 6. Trust 2 filed a QSST
election effective Date 6. X represents that each of the subtrusts of Trust 3 would also
have qualified as a QSST under § 1361(d)(1) except for the fact that the sole
beneficiaries of each of those subtrusts failed to make the election under § 1361(d)(2).

       On Date 7, B purchased the X stock held by Trust 3B, Trust 3C, and Trust 3D.

      In Year 2, X’s accountant discovered the failure of the beneficiaries of the
subtrusts of Trust 3 to file the respective QSST elections, and notified X that its
S corporation election had terminated.

       X represents that all income has been reported on all affected returns consistent
with the treatment of X as an S corporation for Year 1 and for all subsequent years. 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 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.

Law and Analysis

      Section 1362(a) provides 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 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, for purposes of subchapter S, the term
"small business corporation" means a domestic corporation which is not an ineligible
PLR-104706-08                                 4


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 the purposes of § 1362(b)(1)(B), a trust
all of which is treated (under title 26, subtitle A, chapter 1, subchapter J, part I, subpart
E of the United States Code) as owned by an individual who is a citizen or resident of
the United States may be a shareholder of an S corporation.

        Section 1361(c)(2)(A)(ii) and § 1.1361-1(h)(1)(ii) of the Income Tax Regulations
provide that, for purposes of § 1361(b)(1)(B), a trust that is described in
§ 1361(c)(2)(A)(i) immediately before the death of the deemed owner and that continues
in existence after such death is a permitted shareholder, but only for the two-year period
beginning on the day of the deemed shareholder's death.

      Section 1.1361-1(h)(3)(i)(B) provides that, if stock is held by a trust described in
§ 1.1361-1(h)(1)(ii), the estate of the deemed owner is generally treated as the
shareholder as of the day of the deemed owner’s death.

        Section 1361(d)(1) provides that, in the case of a qualified subchapter S trust
with respect to which a beneficiary makes an election under § 1361(c)(2), (A) such trust
will be treated as a trust described in § 1361(c)(2)(A)(i), and (B) for purposes of § 678(a)
the beneficiary of such trust shall be treated as the owner of that portion of the trust
which consists of stock in an S corporation with respect to which the election under
§ 1361(d)(2) is made.

       Section 1361(d)(2)(A) provides that a beneficiary of a QSST (or his legal
representative) may elect to have § 1361(d) apply. Section 1361(d)(2)(D) provides that
an election under § 1362(d)(2) shall be effective up to 15 days and 2 months before the
date of the election.

        Section 1361(d)(3) provides that the term “qualified subchapter S trust” means a
trust (A) the terms of which require that (i) during the life of the current income
beneficiary, there shall be only 1 income beneficiary of the trust, (ii) any corpus
distributed during the life of the current income beneficiary may be distributed only to
such beneficiary, (iii) the income interest of the current income beneficiary in the trust
shall terminate on the earlier of such beneficiary's death or the termination of the trust,
and (iv) upon termination of the trust during the life of the current income beneficiary,
the trust shall distribute all of its assets to such beneficiary, and (B) all of the income
(within the meaning of § 643(b)) of which is distributed (or required to be distributed)
currently to 1 individual who is a citizen or resident of the United States.

      Section 1.1361-1(j)(3) provides that for purposes of § 1361(c) and § 1361(d), a
substantially separate and independent share of a trust, within the meaning of § 663(c)
and the regulations thereunder is treated as a separate trust. For a separate share
which holds S corporation stock to qualify as a QSST, the terms of the trust applicable
PLR-104706-08                                 5


to that separate share must meet the QSST requirements stated in § 1.1361-1(j)(1)(i)
and (ii).

        Section 1.1361-1(j)(6)(iii) provides that if S corporation stock is transferred to a
trust, the QSST election must be made within the 16-day-and-2-month period beginning
on the day that the stock is transferred to the trust.

       Section 1.1361-1(j)(6)(iii)(C) provides that if a trust ceases to be a qualified
subpart E trust, satisfies the requirements of a QSST, and intends to become a QSST,
the QSST election must be filed within the 16-day-and-2-month period beginning on the
date on which the trust ceases to be a qualified subpart E trust. If the estate of the
deemed owner of the trust is treated as the shareholder under § 1.1361-1(h)(3)(i), the
QSST election may be filed at any time, but no later than the end of the 16-day-and-2-
month period beginning on the date on which the estate of the deemed owner ceases to
be treated as a shareholder.

       Section 1.1361-1(j)(7)(i) provides that the income beneficiary who makes the
QSST election and is treated (for purposes of § 678(a)) as the owner of that portion of
the trust that consists of S corporation stock is treated as the shareholder for purposes
of §§ 1361(b)(1), 1366, 1367, and 1368.

      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 first taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation. The termination is effective on and after the day of the termination.

        Section 1362(f) provides that if (1) an election under § 1362(a) by any
corporation 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; (2) the Secretary determines that the circumstances
resulting in such ineffectiveness were inadvertent; (3) no later than a reasonable period
of time after discovery of the circumstances resulting in such ineffectiveness, steps
were taken so that the corporation for which the election was made is a small business
corporation, or to acquire the required shareholder consents; and (4) the corporation for
which the election was made, and each person who was a shareholder in such
corporation at any time during the period specified pursuant to § 1362(f), agrees to
make such adjustments (consistent with the treatment of such corporation as an S
corporation) as may be required by the Secretary with respect to such period, then,
notwithstanding the circumstances resulting in such ineffectiveness, such corporation
shall be treated as an S corporation during the period specified by the Secretary.

Conclusion

      Based solely on the information submitted and the representations made, we
conclude that X's S corporation election was terminated on Date 5, when Trust 1
became an ineligible shareholder. We further conclude that the termination of X’s S
PLR-104706-08                                 6


corporation election was an inadvertent termination within the meaning of § 1362(f).
Accordingly, pursuant to the provisions of § 1362(f), X will be treated as an
S corporation from Date 5 and thereafter, provided that X's S corporation election was
otherwise valid and, except for the failures of the beneficiaries of the subtrusts of Trust 3
to file QSST elections as described above, has not otherwise terminated under
§ 1362(d).

        This ruling is contingent on the beneficiary of Trust 3A filing a QSST election
effective Date 6 within 60 days of the date of this letter. A copy of this letter should be
attached to the QSST election. A copy is provided for that purpose.

        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 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.

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the transactions described above under any other
provision of the Code. Specifically, we express or imply no opinion regarding whether X
is otherwise eligible to be an S corporation.

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

       In accordance with a power of attorney on file with this office, a copy of this letter
is being sent to X's authorized representative.


                                       Sincerely,

                                       Audrey W. Ellis

                                       Audrey W. Ellis
                                       Senior Counsel, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosures (2)
      Copy of this letter
      Copy for §6110 purposes



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