PLR 200908007: Missed trust election caused an inadvertent S corporation termination

Plain-English summary

A grantor trust held stock in an S corporation and remained an eligible shareholder for two years after its deemed owner died. The trustee failed to elect electing small business trust status when that two-year period ended, causing the corporation's S election to terminate. After discovering the error, the trustee distributed the shares to the trust's individual beneficiaries. The IRS found the termination inadvertent and allowed the corporation's S status and the trust's ESBT treatment to continue from the termination date. Relief depended on the company, trust, and shareholders filing and reporting consistently with that treatment.

Ruling snapshot

• Question: Could the company retain S status after a trust shareholder failed to make a timely ESBT election?
• Outcome: Approved: the termination was inadvertent, subject to consistent treatment by the company, trust, and shareholders.
• Key authorities: IRC §§ 1361(c)(2) and (e), 1362(d) and (f), and 1366 through 1368; Treas. Reg. § 1.1361-1(m)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200908007
Third Party Communication: None
Release Date: 2/20/2009
Date of Communication: Not Applicable
Index Number: 1362.01-03, 1362.04-00
Person To Contact:
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---------------------, ID No. ------------
------------------------------------------- Telephone Number:
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-------------------------------------------- Refer Reply To:
CC:PSI:B03
PLR-125675-08
Date: November 13, 2008

Company = ---------------------------------------
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W = ---------------------------------

Trust = --------------------------------------------
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State = -------------

a = --------------------------

b = -----------------------

c = ----------------

d = ----------------

e = ------------------

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

We received a letter dated June 3, 2008, and subsequent correspondence, submitted on behalf of Company requesting a ruling under § 1362(f) of the Internal Revenue Code. This letter responds to that request.

FACTS

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The information submitted states that Company was formed in a, under the laws of State. Company subsequently made an election to be treated as a subchapter S corporation effective on b. Soon after Company’s S corporation election, Trust, a grantor trust described in § 1361(c)(2)(A)(i), the deemed owner of which was W, became a shareholder of Company.

On c, W died. Trust qualified under § 1361(c)(2)(A)(ii) as an eligible shareholder for two years from that date of death. Company represents that as of c Trust qualified as an electing small business trust (“ESBT”). However, the trustee of Trust failed to properly file the ESBT election. As a result, Company’s S corporation election terminated on d, after the two-year period following W’s death. Upon discovering the failure to make the ESBT election, the trustee distributed the Company stock held by Trust to the individual beneficiaries of Trust on e.

Company represents that the circumstances resulting in the termination of Company’s S corporation election were inadvertent and were not motivated by tax avoidance or retroactive tax planning. Company and its shareholders have agreed to make such adjustments, consistent with the treatment of Company as an S corporation, as may be required by the Service.

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) provides that the term “small business corporation” means a domestic corporation which is not an ineligible corporation 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 one class of stock.

Section 1361(c)(2)(A)(i) provides that for purposes of § 1361(b)(1)(B), a trust all of which is treated (under subpart E of part I of subchapter J of chapter 1) as owned by an individual who is a citizen or resident of the United States, may be an S corporation shareholder.

Section 1361(c)(2)(A)(ii) provides that for purposes of § 1361(b)(1)(B), a trust which was described in § 1361(c)(2)(A)(i) immediately before the death of the deemed owner and which continues in existence after such death may be a shareholder, but only for the 2-year period beginning on the day of the deemed owner’s death.

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Section 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT may be a shareholder.

Section 1361(e)(1)(A) provides that for purposes of § 1361, 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), (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 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 1.1361-1(m)(2)(i) of the Income Tax Regulations provides, in part, that the trustee of the trust must make the ESBT election by signing and filing, with the service 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)(A) 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. Section 1362(d)(2)(B) provides that any termination 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 was terminated under § 1362(d)(2) or (3), (2) the Secretary determines that the circumstances resulting in such termination were inadvertent, (3) no later than a reasonable period of time after discovery of the circumstances resulting in such 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 in the corporation at any time during the period specified pursuant to § 1362(f), agrees to make 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 such termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

Based solely on the facts submitted and representations made, we conclude that Company’s election to be treated as an S corporation terminated on d, upon the failure by the trustee of Trust to properly file an ESBT election for Trust. We also conclude that the termination constituted an inadvertent termination within the meaning of § 1362(f).

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Accordingly, Company will be treated as continuing to be an S corporation from d, and thereafter, provided that Company’s S corporation election is not otherwise terminated under § 1362(d).

Moreover, Trust will be treated as an ESBT from d, and thereafter, provided Trust files income tax returns for this period consistent with the trustee of Trust having made an ESBT election for Trust.

This ruling is contingent on Company and all its shareholders treating Company as having been an S corporation for the period beginning on d, and thereafter. The shareholders of Company, including Trust treated as an ESBT, must include their pro rata share of the separately stated and nonseparately computed items of Company as provided in § 1366, make any adjustments to basis as provided in § 1367, and take into account any distributions made by Company as provided in § 1368. If Company or Company’s shareholders fail to treat themselves as described above, this ruling shall be null and void.

Except as expressly provided herein, we express or imply no opinion concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, we express or imply no opinion regarding whether Company is otherwise eligible to be treated as an S corporation or whether Trust was eligible to be treated as an ESBT.

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

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to Company’s authorized representative.

Sincerely,

/s/

Leslie H. Finlow
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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