PLR 200851011: a death, an untimely ESBT election, and sixty days to undo an S termination

Plain-English summary

A shareholder died, and the death quietly destroyed the corporation's S election. A held stock in X, an S corporation. On d3 A died, and on d4 A's stock passed to a trust. A trust can hold S corporation stock, but only certain kinds, and one qualifying kind is an electing small business trust. That status is not automatic. Someone has to elect it, and under section 1361(e)(3) the trustee makes the election. No election was made. The trust was therefore an ineligible shareholder the moment it received the stock, and X stopped being an S corporation on d4.

Nobody noticed at the time. The corporation kept filing as an S corporation and the shareholders kept reporting their income that way, which is the ordinary pattern in these letters: the termination is discovered years later, usually by a new advisor, and by then the returns are all inconsistent with the law.

Section 1362(f) exists for exactly this. If the Service determines the termination was inadvertent, that corrective steps were taken within a reasonable time after discovery, and that the corporation and its shareholders will accept whatever adjustments the Secretary requires, the corporation can be treated as having remained an S corporation throughout. The regulation at section 1.1362-4(b) puts the burden on the corporation and treats an event outside the corporation's control, not part of any plan to terminate, as tending to show inadvertence. A shareholder's death fits that description well.

Relief was granted. X is treated as continuing to be an S corporation on and after d4, on the condition that the trustee files the ESBT election with the appropriate service center within sixty days of the letter, effective as of d4, with a copy of the letter attached.

There is a real tension in how the letter closes. The relief is conditioned entirely on the trust making an ESBT election, yet the final paragraph states that no opinion is expressed regarding X's eligibility to be an S corporation or the trust's eligibility to be an ESBT. The Service grants relief that depends on a status it declines to confirm. The corporation's own representation that the trust satisfies section 1361(e) is carrying that weight, not any determination made here.

The letter misstates the statute it is applying. Its summary of section 1361(b)(1) describes a small business corporation as "a domestic corporation which is not an ineligible shareholder", where the statute reads ineligible corporation. A corporation is not a shareholder of itself, so the sentence does not parse on its own terms. The error is reproduced as released and is not corrected here.

The quotation of section 1362(f) is also damaged. It runs "if an election under § 1362(a) by any corporation was terminated under § 1362(d)(2) or (3); (2) the Secretary determines", so the enumerated list begins at clause (2) with no clause (1) anywhere. The first element was folded into the introductory phrase and lost its number. Both defects are left exactly as printed.

The legend carries a fourth oddity. The entry "Shareholders" is followed by four separate redacted values on four separate lines, one label serving what appear to be four distinct people. Every other legend entry in the letter pairs one name with one value.

The text came out of the PDF digitally rather than through optical character recognition, so no corrections were needed. Redacted values appear as runs of dashes, which is how the IRS released them.

Ruling snapshot

• Question: Where an S corporation's stock passed to a trust on the death of a shareholder and no electing small business trust election was ever filed, making the trust an ineligible shareholder and terminating the S election, was the termination inadvertent within the meaning of section 1362(f)?
• Outcome: Approved. The termination on d4 was inadvertent, and X will be treated as continuing to be an S corporation on and after d4 unless its election is otherwise terminated under section 1362(d), provided the trustee files the ESBT election within sixty days of the letter to be effective d4. No opinion was expressed on X's eligibility to be an S corporation or on the trust's eligibility to be an ESBT.
• Key authorities: IRC sections 1361(b)(1), 1361(c)(2)(A)(v), 1361(e) and 1361(e)(3), 1362(a), 1362(d)(2)(A) and 1362(f); Treas. Reg. sections 1.1362-4(b) and 1.1362-4(d).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200851011 Third Party Communication: None
Release Date: 12/19/2008 Date of Communication: Not Applicable Person To Contact: Index Number: 1362.04-00, 1361.03-03 ---------------------, ID No. ------------ Telephone Number:
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--------------------------------- Refer Reply To:
------------------------------------ CC:PSI:B03
---------------------- PLR-115245-08
-------------------------- Date:
September 10, 2008

Legend

X = ---------------------------------
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A = ----------------
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Trust = ------------------------------------------------------------------------
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Shareholders

= ----------------
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= ----------------------
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=-----------------------
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= ------------------------------------------------------------------------
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State = -------------

d1 =---------------------------

d2 = ---------------------

d3 = -----------------------
d4 = ---------------------

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

This letter responds to your letter dated March 19, 2008, and subsequent correspondence, submitted on behalf of X, requesting a ruling under § 1362(f) of the Internal Revenue Code.

Facts

X was incorporated under the laws of State on d1. X elected to be an S corporation effective d2. On d3, A died. On d4, A’s stock in X was transferred to Trust. Because no election was made under § 1361(e)(3) to treat Trust as an Electing Small Business Trust (ESBT), Trust was an ineligible shareholder on d4. As a result, X’s S corporation election terminated on d4.

X represents that there was no intent to terminate X’s S corporation election and that the failure to timely file the ESBT election for Trust was not motivated by tax avoidance or retroactive tax planning. For all taxable years, X’s Shareholders income was reported consistent with X qualifying as an S corporation. In addition, X and the Shareholders agree to make any adjustments consistent with the treatment of X as an S corporation as may be required by the Secretary with respect to the period specified by
§ 1362(f). X represents that Trust complies with the requirements under § 1361(e), which defines an ESBT.

Law and Analysis

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) defines a “small business corporation” as a domestic corporation which is not an ineligible shareholder 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 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT is a permissible shareholder.

Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), the term “electing small business trust” 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)-(5), or (IV) an organization described in § 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary, (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. Any such election shall apply to the taxable year of the trust for which made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

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 1362(f) provides, in relevant part, that if an election under § 1362(a) by any corporation 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 such ineffectiveness or termination, steps were taken so that the corporation for which the termination occurred is a small business corporation; and (4) the corporation for which the termination occurred, and each person who was a shareholder of the corporation at any time during the period specified pursuant to § 1362(f), agree to make the adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to this period, then, notwithstanding the circumstances resulting in termination, the corporation shall be treated as an S corporation 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 solely on the facts submitted and representations made, we conclude that X’s S corporation election was terminated on d4, when stock in X was transferred to Trust, because Trust failed to timely file the required ESBT election under § 1361(e)(3). We further conclude that the termination was inadvertent within the meaning of
§ 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation on and after d4, unless X’s S corporation election is otherwise terminated under § 1362(d), provided that the trustee of Trust files an ESBT election with the appropriate service center within 60 days of the date of this letter to be effective d4. A copy of this letter should be attached to the ESBT election.

Except for the specific ruling above, no opinion is expressed or implied concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed or implied regarding X’s eligibility to be an S corporation or Trust’s eligibility to be an ESBT.

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 who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.

Sincerely,

/s/

James A. Quinn
Senior Counsel, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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