PLR 201106005: S corporation status preserved after an inadvertent ineligible-shareholder issue

Plain-English summary

The IRS considered a corporation that had elected S corporation status and whose wholly owned subsidiary was treated as a disregarded entity. An employee of the subsidiary became entitled under an equity incentive plan to receive company stock, but the company later learned that the employee was ineligible to be an S corporation shareholder. The IRS concluded that the possible termination of the S corporation election was inadvertent and allowed the company to continue being treated as an S corporation from the redacted date onward, provided the election was not otherwise terminated. The company and its shareholders had to treat the company consistently as an S corporation and make the required income, basis, and distribution adjustments.

Ruling snapshot

• Question: Could the corporation continue its S corporation status after a possible inadvertent termination caused by an ineligible shareholder?
• Outcome: Approved.
• Key authorities: IRC §§ 1361, 1362, 1366, 1367, and 1368.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201106005
Third Party Communication: None
Release Date: 2/11/2011
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B03
PLR-128488-10
Date:
November 09, 2010

LEGEND

Company = -------------------------------------------
-----------------------------------------------------------

Subsidiary = -------------------------------------------------------
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State = -------------

Individual = --------------------

Country = -----------

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

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

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

We received a letter dated July 2, 2010, and subsequent correspondence, submitted on behalf of Company by its authorized representative requesting a ruling under § 1362(f) of the Internal Revenue Code (Code). This letter responds to that request.

FACTS
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Company is a State corporation that elected to be an S corporation effective a.
Company wholly owns Subsidiary, a State limited liability company treated as a disregarded entity for federal tax purposes.

Company started an equity incentive plan (“Plan”) under which key employees of Company and Subsidiary are awarded participation units entitling the holder to a lump sum payment upon the occurrence of certain events. Under the Plan, if an employee holds a certain number of participation units, the employee is entitled to both cash and Company stock.

On b, one of Subsidiary’s employees, Individual, a citizen of Country, became entitled under the Plan to receive cash and Company stock. Before any shares of Company stock were transferred to Individual, however, Company became aware of Individual’s ineligibility as a shareholder. Under a shareholders’ agreement between Company and its shareholders, Company is prohibited from making any transfer of Company stock that would terminate its S corporation election without certain approval.

Company represents that the circumstances resulting in the possible termination of Company’s S corporation election were inadvertent and were not motivated by tax avoidance. 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 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, in part, that if (1) an election under § 1362(a) was terminated under § 1362(d)(2) or (3); (2) the Secretary determines that the
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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 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 such termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSIONS

Based solely on the facts submitted and the representations made, we conclude that Company's S corporation election may have terminated due to an ineligible shareholder. In addition, we conclude that the possible termination was inadvertent within the meaning of § 1362(f). Accordingly, Company will continue to be treated as an S corporation from b, and thereafter, provided Company's S corporation election is not otherwise terminated under § 1362(d). However, this ruling is contingent on Company and its shareholders treating Company as having been an S corporation from b, and thereafter. Accordingly, Company's shareholders must include their pro rata shares of the separately stated and nonseparately computed items of income or loss of Company under § 1366, make any adjustments to stock basis under § 1367, and take into account any distributions made by Company to shareholders under § 1368.

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.

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.
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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/

Mary Beth Carchia
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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