PLR 200852015: S election restored after an ineligible shareholder acquired stock, on condition the shareholders report consistently

Plain-English summary

An S corporation can only have certain kinds of shareholders. When stock lands in the hands of someone outside that list, the S election terminates by operation of law on the day it happens. Nobody has to intend it and nobody has to notice. That is what occurred here. Stock in the company passed to a shareholder who was not eligible, and the election ended on that date.

Section 1362(f) is the repair provision for exactly this situation, and it has four moving parts. The Service must determine the termination was inadvertent. The company must have taken corrective steps within a reasonable period after discovering the problem. The company and everyone who was a shareholder during the lapsed period must agree to whatever adjustments the Commissioner requires, consistent with being treated as an S corporation throughout. If all of that holds, the company is treated as having been an S corporation for the period the Service specifies, as though the termination had never happened.

The company met each element. It found the problem, and shortly afterward entered an agreement transferring the ineligible shareholder's stock to an eligible one. It represented that the termination was not motivated by tax avoidance or retroactive tax planning, and it and its shareholders agreed to make any adjustments required. The Service concluded the termination was inadvertent and held the company continues to be treated as an S corporation from the date of termination onward.

The relief comes fenced in. It holds only if the original S election was valid to begin with, which the letter does not decide. It is also conditioned on downstream behaviour: the shareholders must include their pro rata shares of the company's separately stated and nonseparately computed items under section 1366, adjust their stock basis under section 1367, and account for distributions under section 1368. The letter states that if the company or its shareholders fail to treat themselves that way, the ruling is null and void. That is unusually direct language, and it means the relief can evaporate later without any further action by the Service.

Two features of the released text are worth recording and are left exactly as the IRS wrote them. The letter closes by citing "Section 6110(j)(3)" as the provision making it non-precedential, whereas the current codification of that rule, and the one quoted in the banner above, is section 6110(k)(3). Separately, the holding is conditioned on the election not having been "otherwise terminated under § 1361(d)," while the termination rules the same letter quotes and relies on appear in section 1362(d). Neither has been altered here.

Ruling snapshot

• Question: Was the termination of a company's S election inadvertent under section 1362(f), where the election ended because an ineligible shareholder acquired stock, so that the company may be treated as having remained an S corporation throughout?
• Outcome: Approved. The termination was inadvertent. The company is treated as continuing to be an S corporation from the termination date onward, provided the original election was valid and was not otherwise terminated, and provided the shareholders report their pro rata shares, basis adjustments and distributions consistently under sections 1366, 1367 and 1368. Failure to do so voids the ruling.
• Key authorities: IRC sections 1361(b), 1361(d), 1362(a), 1362(b)(2), 1362(d)(2) and (3), 1362(f), 1366, 1367 and 1368.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200852015 Third Party Communication: None
Release Date: 12/26/2008 Date of Communication: Not Applicable Index Number: 1362.04-00 Person To Contact:
------------------------------ -------------------, ID No. ------------
------------ Telephone Number:

------------------------------------------------ Refer Reply To: CC:PSI:B02 PLR-111742-08 Date: September 04, 2008

X = ---------------
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Date 1= -------------------------

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

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

A = ---------------------------
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B = -------------------
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Dear ---------------:

This responds to a letter dated February 7, 2008, submitted on behalf of X, requesting a ruling under § 1362(f) of the Internal Revenue Code.

X made an election to be treated as an S corporation. X’s election was inadvertently terminated effective Date 1 when A, an ineligible S corporation shareholder, became the owner of X stock. X discovered this problem on Date 2 and on Date 3 entered into an agreement to transfer the X stock owned by A to B, an eligible S corporation shareholder. X represents that the termination 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 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 the termination of X’s S corporation election on Date 1 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 Date 1 and thereafter, provided X’s S corporation election was valid and provided that the election was not otherwise terminated under § 1361(d).

This ruling is conditioned upon the shareholders of X including in income their pro rata share of the separately stated and nonseparately computed items of X as provided in § 1366, making any adjustments to basis as provided in § 1367, and taking into account any distributions made by X as provided in § 1368. If X or its shareholders fail to treat themselves as described above, this letter ruling shall be 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.

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

Pursuant to a power of attorney on file, a copy of this letter is being sent to X’s authorized representatives.

Sincerely,

Michael Skeen
Acting Chief, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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