PLR 1031030: IRS treated an S corporation as continuing after an inadvertent termination

Plain-English summary

The IRS concluded that an S corporation's election had terminated because the corporation had accumulated earnings and profits and more than 25 percent of its gross receipts were passive investment income for three consecutive years. The IRS also concluded that the termination was inadvertent. The corporation could therefore be treated as continuing to be an S corporation from the termination date, provided the election was valid and had not otherwise terminated. The corporation agreed to distribute its accumulated earnings and profits through a deemed dividend and make any required adjustments.

Ruling snapshot

• Question: Could the corporation receive relief from an inadvertent termination of its S corporation election under IRC § 1362(f)?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(d)(3), 1362(f), 1368, and 1375; Treas. Reg. § 1.1368-1(f)(3)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201031030 Third Party Communication: None
Release Date: 8/6/2010 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------ -----------------, ID No. -------------------------
----------------------------- --------
------------------------ Telephone Number:
--------------------------------- ---------------------
Refer Reply To:
CC:PSI:1
PLR-151867-09
Date:
April 29, 2010

                                                    Legend

X = ------------------------------

State = ------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

Year 5 = -------

$n = -----------

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

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

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

   This letter responds to your letter dated --------------------------, and subsequent

correspondence, submitted on behalf of X, requesting a ruling under § 1362(f) of the
Internal Revenue Code.

                                                     Facts

PLR-151867-09 2

   X was incorporated under the laws of State in Year 1. X elected to be an S

corporation effective Date 1. At the time X made its S election, X’s accountants
believed that X did not have accumulated earnings and profits. For each of the
consecutive years of Year 2, Year 3, and Year 4, X had passive investment income in
excess of 25 percent of its yearly gross receipts. During Year 5, X engaged a new
accountant who determined that X had accumulated earnings and profits of $n. X will
elect pursuant to § 1.1368-1(f)(3) of the Income Tax Regulations to distribute all of its
accumulated earnings and profits, $n, to its shareholders through a deemed dividend in
Year 5.

  X represents that X and its shareholders did not intend to terminate X’s S

corporation election and were not aware of the termination until Year 5. X and its
shareholders have treated X as an S corporation since Date 1. X represents that the
termination was not motivated by tax avoidance or retroactive tax planning. X and X’s
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).

                                Law and Analysis

  Section 1361(a)(1) provides that the term “S corporation” means a small

business corporation for which an election under § 1362(a) is in effect for the taxable
year.

   Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be

terminated whenever the corporation has accumulated earnings and profits at the close
of each of three consecutive taxable years, and has gross receipts for each of such
taxable years more than 25 percent of which are passive investment income. Section
1362(d)(3)(A)(ii) provides that any termination under § 1362(d)(3) becomes effective on
and after the first day of the first taxable year beginning after the third consecutive
taxable year referred to in § 1362(d)(3)(A)(i).

    Section 1362(d)(3)(C)(i) provides that, except as otherwise provided in

§ 1362(d)(3)(C), “passive investment income” means gross receipts derived from
royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or
securities.

    Section 1362(f) provides, in relevant part, 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 of the corporation at any
time during the period specified pursuant to § 1362(f), agrees to make the adjustments
PLR-151867-09 3

(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 the termination, the corporation shall be treated as an S
corporation during the period specified by the Secretary.

  Section 1368(c) provides rules for determining the source of distributions made

by an S corporation having accumulated earnings and profits with respect to its stock.
Section 1368(e)(3) and § 1.1368-1(f)(2) provide that an S corporation may, with the
consent of all its affected shareholders, elect to distribute earnings and profits first.

    Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or

part of its accumulated earnings and profits through a deemed dividend. If an S
corporation makes the election provided in § 1.1368-1(f)(3), the S corporation will be
considered to have made the election under § 1368(e)(3) and § 1.1368-1(f)(2) to
distribute earnings and profits first.

   Section 1375 imposes a tax on the income of an S corporation that has

accumulated earnings and profits at the close of a taxable year, and that has gross
receipts more than 25 percent of which are passive investment income (within the
meaning of § 1362(d)(3)).

                                    Conclusion

   Based solely on the facts submitted and representations made, we conclude that

X’s S corporation election terminated on Date 2 under § 1362(d)(3)(A) because X had
accumulated earnings and profits at the close of each of three consecutive taxable
years beginning in Year 2, and gross receipts for each of those taxable years more than
25 percent of which were passive investment income.

   We further conclude that the termination of X’s S corporation election was an

inadvertent termination within the meaning of § 1362(f). Pursuant to § 1362(f), X will be
treated as continuing to be an S corporation beginning on Date 2 and thereafter,
provided that X’s S corporation election was valid and has not otherwise terminated
under § 1362(d).

   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 regarding whether X’s S
election is otherwise valid.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalties 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 rulings, it is subject to verification on
examination.
PLR-151867-09 4

  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.

    Under a power of attorney on file with this office, we are sending a copy of this

letter to your authorized representative.

                                   Sincerely,

                                     /s/

                                   David R. Haglund
                                   Chief, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)