PLR 201016025: Corporation's S election continues after inadvertent ineligible shareholder

Plain-English summary

The IRS ruled that a corporation's S corporation election terminated when it transferred stock to an entity that was an ineligible S corporation shareholder. The ineligible entity later distributed most of the stock to other owners and became a disregarded entity owned by one shareholder. Because the termination was inadvertent and corrective steps were taken, the IRS allowed the corporation to be treated as continuing to be an S corporation from the termination date. The corporation and its shareholders had to report consistently with S corporation treatment and make the required basis, income, and distribution adjustments. The ruling became void if those conditions were not met.

Ruling snapshot

• Question: May an S corporation continue its status after an inadvertent termination caused by an ineligible shareholder?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(d), and 1362(f)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201016025
Third Party Communication: None
Release Date: 4/23/2010
Date of Communication: Not Applicable
Person To Contact:
Index Number: 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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Date:
December 10, 2009

LEGEND

Company = --------------------
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LLC = -------------------------
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A = ----------------
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B = -----------------
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C = ---------------------
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D = --------------------
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E = ----------------
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State = -------------

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

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

c = ---------------------------
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d = -------------------------

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

We received a letter dated June 17, 2009, and subsequent correspondence, submitted on behalf of Company by its authorized representative requesting a ruling under § 1362(f) of the Internal Revenue Code. This letter responds to that request.

FACTS

Company was formed on a, under the laws of State. Company filed Form 2553, Election by a Small Business Corporation, to be treated as an S corporation effective on b. On c, Company transferred shares of Company stock to LLC, which was owned by A, B, C, D, and E and treated as a partnership for federal tax purposes. As a result of the transfer, Company had an ineligible S corporation shareholder. When it later became known that LLC was an ineligible shareholder, LLC distributed to B, C, D, and E their pro rata shares of Company stock on d. LLC, which continued to hold A’s shares of Company stock, then became a disregarded entity solely owned by A.

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 for purposes of title 26, 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 for purposes of subchapter S, 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 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
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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) or § 1361(b)(3)(B)(ii) 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 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 (A) so that the corporation for which the election was made or the termination occurred is a small business corporation or a qualified subchapter S subsidiary, as the case may be, 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 or a qualified subchapter S subsidiary, as the case may be) as may be required by the Secretary with respect to such period, then, notwithstanding the circumstances resulting in such ineffectiveness or termination, the corporation shall be treated as an S corporation or a qualified subchapter S subsidiary, as the case may be, during the period specified by the Secretary.

CONCLUSIONS

Based solely on the facts submitted and representations made, we conclude that Company’s election to be treated as an S corporation terminated on c, when LLC became an ineligible S corporation shareholder. We also conclude that the termination constituted an inadvertent termination within the meaning of § 1362(f). Accordingly, Company will be treated as continuing to be an S corporation from c, and thereafter, provided that Company’s S corporation election is not otherwise terminated under § 1362(d). This ruling is contingent upon A, B, C, D, and E being treated as owning Company stock held by LLC in proportion to their ownership interests in LLC on c, and thereafter; and upon Company and all its shareholders treating Company as having been an S corporation for the period beginning on c, and thereafter. The shareholders of Company must include their pro rata shares 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
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in this letter. Specifically, we express or imply no opinion regarding whether Company is otherwise eligible to be treated as an S corporation.

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.

Under a Power of Attorney on file with this office, we are sending a copy of this letter to Company’s authorized representative.

Sincerely,

/s/

Christine Ellison
Chief, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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