PLR 200851003: consent to re-elect S status denied over two shareholders' section 1042 elections

Plain-English summary

This is a denial, which makes it unusual in a release otherwise full of granted relief. X was incorporated in State on D1 and elected S corporation status effective D2. On D3 it ended that status deliberately, recapitalizing its common stock into common stock and ESOP convertible preferred stock. Two classes of stock meant X was no longer a small business corporation, so the election terminated under section 1362(d)(2)(A). On D4 the four shareholders sold the convertible preferred stock to X's ESOP and two of them elected section 1042 treatment to defer their gain. On D5 X redeemed all of its common stock, leaving the ESOP as the sole shareholder. X then asked the Service to consent under section 1362(g) to a fresh S election effective D6, before the five taxable year waiting period had run.

The Service refused, and the reason is a mismatch the taxpayer created for itself. Section 1042 lets a shareholder defer gain on a sale of qualified securities to an ESOP, but qualified securities under section 1042(c)(1) must be employer securities issued by a domestic C corporation. The ESOP itself was no obstacle, since section 1361(c)(6) lets an organization described in section 401(a) hold S corporation stock. The obstacle was that two shareholders had already claimed a benefit available only to shareholders of a C corporation. Restoring subchapter S treatment from D6 would be inconsistent with those elections.

What makes the letter instructive is the factor it sets aside. Section 1.1362-5(a) says that ownership of more than 50 percent of the stock by persons who held none on the termination date tends to establish that consent should be granted, and that absent such a fact consent is ordinarily denied. The D5 redemption produced exactly that change, moving the entire company to the ESOP. The Service held that the section 1042 elections precluded relief without regard to that change. The regulation's principal affirmative factor was present and the request still failed.

The letter is careful about its own edges. It notes that X was not asking for a ruling on the validity of the shareholders' section 1042 elections, and it reserves both on those elections and on whether X was or is eligible to be an S corporation without regard to the transactions described.

Three defects in the released text are left as published. The letter expands ESOP as "employee stock option plan" where the term is employee stock ownership plan, and the section 4975(e)(7) definition it goes on to cite is the ownership plan definition. Its quotation of section 1.1362-5(a) reads "not reasonably within the control of the corporation of shareholders having a substantial interest", where the sense requires or rather than of. And the facts refer once to "the total ownership interests in Taxpayer" although the legend defines X and never defines Taxpayer, the same kind of stray token that appears in PLR 200851014. This document also carries no legend heading at all. Its defined terms begin immediately below the date line.

Ruling snapshot

• Question: Will the Service consent under section 1362(g) to a new S corporation election effective D6, before the five taxable year waiting period that follows the D3 termination has run?
• Outcome: Denied. The section 1042 elections made by two shareholders on the D4 sale to the ESOP preclude relief, without regard to the more than 50 percent ownership change caused by the D5 redemption.
• Key authorities: Sections 1042(a) and 1042(c)(1), 1361(b)(1)(B), 1361(c)(6), 1362(d)(2)(A), 1362(g) and 4975(e)(7); section 1.1362-5(a) of the Income Tax Regulations.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200851003 Third Party Communication: None
Release Date: 12/19/2008 Date of Communication: Not Applicable Person To Contact: Index Number: 1362.01-02 --------------------, ID No. ------------ Telephone Number:
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----------------------------------------- Refer Reply To:
-------------------------------------------- CC:PSI:B02
---------------------------------------- PLR-112943-08
---------------------------- Date:
September 09, 2008

X = ------------------------------------------------------------------------------------------------------
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State = ------------------------------------------------------------------------------------------------------
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A = ------------------------------------------------------------------------------------------------------
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B = ------------------------------------------------------------------------------------------------------
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C = ---

E = ---

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

D4 = ------------------------------------------------------------------------------------------------------
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D5 = ------------------------------------------------------------------------------------------------------
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D6 = ---------------------

Dear ---------------
This responds to a letter dated March 14, 2008, and subsequent correspondence submitted on behalf of X by X’s authorized representative, requesting a ruling under
§ 1362(g) of the Internal Revenue Code.

FACTS

The information submitted states that X was incorporated under the laws of State on D1 and elected to be an S corporation effective D2. On D3, X terminated its S election by recapitalizing its common stock (A% ownership interest in X) into common stock (B% ownership interest in X) and employee stock option plan (ESOP) convertible preferred stock (C% ownership interest in X). On D4, the four X shareholders sold the ESOP convertible stock (C% ownership interest in X) to X’s ESOP and two shareholders elected § 1042 treatment on the sale of their stock. Section 1042 treatment was elected for the sale of approximately E% of the total ownership interests in Taxpayer. On D5, X redeemed all of its common stock causing the X ESOP to become the sole X shareholder.

X requests permission under § 1362(g) to reelect S corporation status effective D6, a date that is prior to the termination of the five year waiting period required by the Code. X is not requesting a ruling on the validity of the shareholder’s § 1042 election.

LAW AND ANALYSIS

Section 1362(a) provides that except as provided in § 1362(g), a small business corporation may elect to be an S corporation.

Section 1361(b)(1) provides, in part, that for the purposes of subchapter S, the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not (B) have as a shareholder a person (other than an estate, trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an individual and (D) have more than one class of stock.

Section 1361(c)(6) provides that for purposes of § 1361(b)(1)(B), an organization which is described in §§ 401(a) or 501(c)(3), and exempt from taxation under § 501(a) may be a shareholder in an S corporation. ESOPs as defined in § 4975(e)(7) are described in
§ 401(a) and exempt from taxation under § 501(a).

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 the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1042(a) provides that if the taxpayer elects the application of § 1042(a) with respect to any sale of qualified securities, the taxpayer purchases qualified replacement property within the replacement period, and the qualified securities are sold to an ESOP holding 30% of the stock after the sale, then the gain (if any) on such sale which would be recognized as long-term capital gain shall be recognized only to the extent that the amount realized on such sale exceeds the cost to the taxpayer of such qualified replacement property. Qualified securities under § 1042(c)(1) must be employer securities issued by a domestic C corporation.

Section 1362(g) provides that if a small business corporation has made an S corporation election under § 1362(a), and if such election has been terminated under
§ 1362(d), the corporation (and any successor corporation) is not eligible to make another election under § 1362(a) for any taxable year before its fifth taxable year which begins after its first taxable year for which the termination is effective, unless the Secretary consents to the election.

Section 1.1362-5(a) provides that the fact that more than 50% of the stock in the corporation is owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted. In the absence of this fact, consent ordinarily is denied unless the corporation shows that the event causing termination was not reasonably within the control of the corporation of shareholders having a substantial interest in the corporation and was not part of a plan on the part of the corporation or of such shareholders to terminate the election.

We deny X’s request to reelect S corporation status under § 1362(g) before the expiration of the five year statutory waiting period. While an ESOP may be an S corporation shareholder under § 1361(b)(1)(B), only C corporation shareholders may sell their stock to an ESOP and defer the gain by electing § 1042 treatment for a qualified stock sale. X terminated its S corporation status on D3 under § 1362(d)(2)(A) when X recapitalized creating two classes of stock. The election of § 1042 treatment by two shareholders with respect to their sale of X stock to the ESOP on D4 precluded
§ 1362(g) relief without regard to the D5 redemption of X stock causing a more than 50% ownership change as described in § 1.1362-5(a).

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the facts described above under any other provision of the Code. Specifically, no opinion is expressed regarding whether X was or is eligible to be an S corporation without regard to the transactions discussed, or concerning the selling shareholders’ § 1042 elections.

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

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

Sincerely,

Bradford R. Poston
Senior Counsel, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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

cc: