IRS grants relief after a trust caused an S corporation election to terminate

Plain-English summary

An S corporation's shares were transferred to a trust after a shareholder died, but the trust held the shares longer than the two-year period allowed for a testamentary trust shareholder. The IRS concluded that the resulting S corporation termination was inadvertent and granted relief under section 1362(f). The corporation would be treated as an S corporation from the termination date if the trust beneficiary made a QSST election within 60 days and the parties made the required consistent tax adjustments. The ruling was contingent on the corporation's original election being valid and was void if the corporation or shareholders failed to follow the required treatment.

Ruling snapshot

• Question: May an S corporation receive relief after its election terminated because a testamentary trust remained a shareholder beyond the permitted period?
• Outcome: Approved, subject to a timely QSST election and consistent reporting.
• Key authorities: IRC §§ 1361, 1362, 1366, 1367, 1368, and 6110(k)(3); Treas. Reg. § 1.1361-1(j)(6)(ii).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200929002
Third Party Communication: None
Release Date: 7/17/2009
Date of Communication: Not Applicable
Person To Contact:
Index Number: 1362.00-00, 1362.04-00
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Telephone Number:
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------------------------------------------- Refer Reply To:
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CC:PSI:B03
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PLR-146119-08
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Date:
April 13, 2009

LEGEND

X = ---------------------------------------------------------------------------------------------------
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A = -----------------------------

B = --------------------------

C = --------------------------

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

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

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

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

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

Date 5 = ---------------------------------------------------------------------------------------------------
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Dear ---------------:

This letter responds to a letter dated August 30, 2008, and subsequent correspondence, submitted on behalf of X by its authorized representative, requesting inadvertent termination relief under § 1362(f) of the Internal Revenue Code (Code).

FACTS

X was incorporated under the laws of State on Date 1 and elected to be an S corporation on Date 1. X had two shareholders, A and B, each holding a 50 percent share of X.

A died on Date 2. On Date 3, A’s shares of X stock were transferred to Trust pursuant to the terms of A’s will. Trust held the X stock longer than the 2-year period prescribed under § 1361(c)(2)(A)(iii). Therefore, Trust became an ineligible shareholder and X’s S corporation election terminated two years after Date 3, on Date 4. X and Trust represent that Trust was eligible to elect to be a qualified subchapter S trust (QSST) as of Date 4, however, no QSST election was made.

On Date 5, Trust made a distribution of all of the X stock to C, the sole beneficiary of Trust, who X represents is a qualified subchapter S shareholder.

X represents that the circumstances resulting in the termination of X’s S corporation election were inadvertent and not motivated by tax avoidance. X further represents that from Date 4, X and its shareholders have filed all returns consistent with X’s status as an S corporation. X and its shareholders have agreed to make such adjustments (consistent with the treatment of X as an S corporation) as may be required by the Secretary.

LAW

Section 1361(a)(1) of the Code 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 the term “small business corporation” to be 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 1 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 a shareholder.

Section 1361(c)(2)(A)(iii) provides that, for purposes of § 1361(b)(1)(B), a trust with respect to stock transferred to it pursuant to the terms of a will may be a shareholder, but only for the 2-year period beginning on the day on which such stock is transferred to it.

Section 1361(d)(1) provides that, in the case of a QSST with respect to which a beneficiary makes an election under § 1361(d)(2), (A) the trust shall be treated as a trust described in § 1361(c)(2)(A)(i), (B) for purposes of § 678(a), the beneficiary of the 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, and (C) for purposes of applying §§ 465 and 469 to the beneficiary of the trust, the disposition of the S corporation stock by the trust shall be treated as a disposition by such beneficiary.

Section 1361(d)(2)(A) provides that a beneficiary of a qualified subchapter S trust (or his legal representative) may elect to have § 1361(d) apply.

Section 1361(d)(2)(D) provides that an election under § 1361(d)(2) will be effective up to 15 days and 2 months before the date of the election.

Section 1.1361-1(j)(6)(ii) of the Income Tax Regulations provides that the current income beneficiary of a QSST must make the election under § 1361(d)(2) by signing and filing with the service center with which the corporation files its income tax returns the applicable form or statement including the information listed in § 1.1361-1(j)(6)(ii).

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 one 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 beneficiary in the trust shall terminate on the earlier of the beneficiary’s death or the termination of the trust, and (iv) upon the termination of the trust during the life of the current income beneficiary, the trust shall distribute all of its assets to that beneficiary, and (B) all of the income (within the meaning of § 643(b)) of which is distributed (or required to be distributed) currently to one individual who is a citizen or resident of the United States.

Section 1362(a)(1) 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 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 a termination of an S corporation election under § 1362(d)(2) is effective on or after the date of cessation.

Section 1362(f) provides, in part, 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) or § 1361(b)(3)(C), (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 such ineffectiveness or termination, steps were taken (A) so that the corporation is a small business corporation or (B) to acquire the required shareholder consents, and (4) the corporation for which the election was made or 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 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 shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that X’s S corporation election terminated on Date 4 because Trust was no longer an eligible shareholder of X. We also conclude that this termination of X’s S election on Date 4 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 the period from Date 4 and thereafter, provided that X’s S corporation election was valid and was not otherwise terminated under § 1362(d). Trust will be treated as a QSST from Date 4 until its termination. This ruling is contingent upon C filing an election effective Date 4 for Trust to be a QSST. This election must be filed within 60 days of the date of this letter with the appropriate service center. A copy of this letter should be attached to the QSST election.

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 any 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 expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

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.

PLR-146119-08
5

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

The ruling contained in this letter is based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for a ruling, it is subject to verification on examination.

Sincerely,

/s/

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

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

cc: