PLR 1032030: The IRS preserved an S corporation election after trusts failed to make ESBT elections

Plain-English summary

The IRS ruled that a corporation's S corporation election was ineffective because three shareholder trusts had not made the required elections to qualify as electing small business trusts. The corporation and its shareholders represented that the problem was inadvertent and not motivated by tax avoidance or retroactive tax planning. The IRS treated the corporation as continuing to be an S corporation from the effective date, provided the trustees filed ESBT elections within 60 days and made any required tax adjustments. The ruling did not address whether the corporation otherwise met the requirements for S corporation status.

Ruling snapshot

• Question: Could the corporation's S corporation election continue after trusts became ineligible shareholders because their ESBT elections were not timely made?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(d), 1362(f), and 6110(k)(3); Treas. Reg. §§ 1.1362-4(b), 1.1362-4(d).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201032030 Third Party Communication: None
Release Date: 8/13/2010 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1362.00-00, 1362.04-00 ---------------------, ID No. -----------------
Telephone Number:
---------------------
------------------------------------------ Refer Reply To:
------------------------------------ CC:PSI:B03
---------------------------------- PLR-153718-09
------------------------------------ Date:
May 05, 2010

                                                LEGEND

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

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

Trust = ----------------------------------------------------------------------------------------------------
2 ------------------------

Trust = ----------------------------------------------------------------------------------------------------
3 -----------------------

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

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

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

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

Date 5 = -------------------------

State = --------------------
1
State = ---------
2
Year = -------

PLR-153718-09 2

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

   This letter responds to a letter dated December 9, 2009, and subsequent

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

                                     FACTS

   X was incorporated under the laws of State 1 on Date 1. X elected to be an S

corporation effective Date 2. At that time, some of X’s stock was held in Trusts 1, 2,
and 3. Trusts 1, 2, and 3 were created under the laws of State 2 on Dates 3, 4, and 5,
respectively. Trusts 1, 2, and 3 made elections to be qualified subchapter S trusts
(QSSTs) effective Date 2. X acknowledges, however, that as of Date 2, Trusts 1, 2, and
3 did not meet the qualifications to be valid QSSTs for purposes of being S corporation
shareholders. X represents that Trusts 1, 2, and 3 were eligible to be electing small
business trusts (ESBTs) within the meaning of § 1361(e), but failed to make the
required elections under § 1361(e)(3). Therefore, Trusts 1, 2, and 3 were ineligible
shareholders, causing X’s S corporation election to be invalid as of Date 2.

   X and its shareholders represent that the circumstances surrounding X’s

ineffective S corporation election and the trustees’ failure to timely file ESBT elections
for Trusts 1, 2, and 3 were inadvertent and not motivated by tax avoidance or
retroactive tax planning. For all taxable years, X reported income consistently with X
qualifying as an S corporation. In addition, X and its 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

    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) defines a “small business corporation” as a domestic

corporation which is not an ineligible shareholder 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)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT

is a permissible shareholder.

PLR-153718-09 3

   Section 1361(e)(1)(A) provides that, 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)-(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 1362(f) provides, in relevant part, that if (1) an election under § 1362(a)

by any corporation 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; (2) the Secretary determines that the
circumstances resulting in such ineffectiveness were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
ineffectiveness, steps were taken (A) so that the corporation for which the election was
made is a small business corporation, or (B) to acquire the required shareholder
consents; and (4) the corporation for which the election was made, 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 (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 such ineffectiveness,
the corporation shall be treated as an S corporation during the period specified by the
Secretary.

    Section 1.1362-4(b) of the Income Tax Regulations provides, in pertinent part,

that, for purposes of § 1.1362-4(a), the determination of whether an invalid election was
inadvertent is made by the Commissioner. The corporation has the burden of
establishing that under the relevant facts and circumstances the Commissioner should
determine that the invalid election was inadvertent. The fact that the invalidity of the
election was not reasonably within the control of the corporation or the fact that the
terminating event or circumstance took place without the knowledge of the corporation,
notwithstanding its due diligence to safeguard itself against such an event or
circumstance, tends to establish that the invalidity of the election was inadvertent.

   Section 1.1362-4(d) provides, in pertinent part, that the Commissioner may

require any adjustments that are appropriate. In general, the adjustments required
should be consistent with the treatment of the corporation as an S corporation during
the period specified by the Commissioner. In the case of stock held by an ineligible
shareholder that causes an invalid election for an S corporation under § 1362(f), the

PLR-153718-09 4

Commissioner may require the ineligible shareholder to be treated as a shareholder of
the S corporation during the period the ineligible shareholder actually held stock in the
corporation. Moreover, the Commissioner may require protective adjustments that
prevent the loss of any revenue due to the holding of stock by an ineligible shareholder
(for example, a nonresident alien).

                                 CONCLUSION

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

X’s S corporation election was ineffective beginning Date 2 because Trusts 1, 2, and 3
were ineligible shareholders. We also conclude that the ineffectiveness of X’s S
corporation election was inadvertent within the meaning of § 1362(f).

    Under § 1362(f), X will be treated as continuing to be an S corporation on and

after Date 2, unless X’s S corporation election is otherwise terminated under § 1362(d),
provided that the trustees of Trusts 1, 2, and 3 file ESBT elections with the appropriate
service center within 60 days of the date of this letter to be effective Date 2. A copy of
this letter should be attached to the ESBT elections. In addition, the trustees of Trusts
1, 2, and 3 must make appropriate adjustments, including filing amended tax returns if
any are required, for the tax years ending after Year to bring Trusts 1, 2, and 3 in
compliance with ESBT requirements.

   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. Specifically, no opinion is expressed as to whether X otherwise
meets the requirements to be an S corporation.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

  In accordance with a power of attorney on file with this office, we are sending a

copy of this letter to your authorized representatives.

PLR-153718-09 5

   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/
                                 James A. Quinn
                                 Senior Counsel, Branch 3
                                 Office of the Associate Chief Counsel
                                 (Passthroughs & Special Industries)

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

cc: