PLR 201123023: IRS restores S corporation treatment after an inadvertent trust-shareholder termination

Plain-English summary

An S corporation's election terminated when a revocable trust holding its shares remained in place after the two-year post-death period for a permitted trust shareholder. The successor trustees transferred the shares to a second trust that represented it was eligible to elect qualified subchapter S trust treatment. The IRS concluded that the termination was inadvertent and that the corporation would be treated as an S corporation from the termination date forward, assuming it remained otherwise eligible and the election was not separately terminated. The relief required the shareholders to make specified income, basis, and distribution adjustments and required the beneficiary of the second trust to file a QSST election within 120 days.

Ruling snapshot

• Question: Can the corporation retain S corporation treatment after a trust-shareholder eligibility problem terminated its election?
• Outcome: Approved.
• Key authorities: IRC §§ 1361, 1362, 1366-1368; Treas. Reg. §§ 1.1361-1, 6110.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201123023
Third Party Communication: None
Release Date: 6/10/2011
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:B02
PLR-147360-10
Date:
February 09, 2011

X = ----------------------------
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A = -------------------------
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Trust 1 = -------------------------------------------------------------------------
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Trust 2 = ------------------------------------------------------------------------------------------
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State = ---------
Date 1 = -------------------------
Date 2 = -------------------------
Date 3 = -----------------------
Date 4 = -------------------
Date 5 = -------------------
Date 6 = -------------------------

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

This responds to a letter dated November 17, 2010, submitted on behalf of X by its authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue Code.

The information submitted states that X was incorporated under the laws of State on Date 1 and elected to be an S corporation effective Date 2. On Date 3, A created Trust 1, a revocable trust under the laws of State. As of Date 3, Trust 1 was funded with shares of X stock. On Date 4, A died and Trust 1 became irrevocable. Trust 1 was a qualifying S corporation shareholder under § 1361(c)(2)(A)(ii) until Date 5, two years after A’s date of death. Trust 1, however, continued to hold X stock until Date 6. As
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such, X’s S corporation election terminated on Date 5 when Trust 1 ceased to be an eligible shareholder.

On Date 6, the successor co-trustees of Trust 1 transferred the X stock that Trust 1 had held to Trust 2. X represents that Trust 2 is eligible to elect qualified subchapter S trust (QSST) treatment under § 1361(d).

X also represents that the circumstances resulting in the termination of X’s S corporation election were inadvertent and were not motivated by tax avoidance or retroactive tax planning. X further represents that at all times since Date 2, X and its shareholders have treated X as an S corporation. X and its shareholders consent to make any adjustments that the Commissioner may require, consistent with the treatment of X as an S corporation.

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)(B) provides that the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not 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.

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 an S corporation shareholder.

Section 1361(c)(2)(A)(ii) and § 1.1361-1(h)(1)(ii) provide that, for purposes of § 1361(b)(1)(B), a trust that is described in § 1361(c)(2)(A)(i) immediately before the death of the deemed owner and that continues in existence after such death is a permitted S corporation shareholder, but only for the two-year period beginning on the day of the deemed owner's death. Section 1.1361-1(h)(3)(i)(B) provides that if stock is held by a trust described in § 1.1361-1(h)(1)(ii), the estate of the deemed owner is generally treated as the shareholder as of the day of the deemed owner's death.

Section 1361(d)(1) provides that in the case of a QSST for which a beneficiary makes an election under § 1361(d)(2), the trust is treated as a trust described in § 1361(c)(2)(A)(i), and for purposes of § 678(a), the beneficiary of the trust shall be treated as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the election under § 1361(d)(2) is made.

Section 1361(d)(2)(A) provides that a beneficiary of a QSST may elect to have § 1361(d) apply. Section 1.1361-1(j)(6)(ii) provides that the current income beneficiary
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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 a statement including the information listed in § 1.1361-1(j)(6)(ii).

Section 1362(d)(2) provides that (A) in general, 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, and (B) any termination under § 1362(d)(2) shall be effective on and after the date of cessation.

Section 1362(f) provides 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), (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 the ineffectiveness or termination, steps were taken (A) so that the corporation is a small business corporation, or (B) to acquire the shareholder consents, and (4) the corporation and each person who was a shareholder of 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 will be treated as an S corporation during the period specified by the Secretary.

Based solely on the facts submitted and the representations made, we conclude that X’s election to be treated as an S corporation was terminated on Date 5 and that this termination was inadvertent within the meaning of § 1362(f). We further conclude that, pursuant to the provisions of § 1362(f), X will be treated as being an S corporation from Date 5 and thereafter, provided that X is otherwise eligible to be an S corporation and provided that the election was not otherwise terminated under § 1362(d).

This ruling is conditioned upon the shareholders of X including in income their pro rata share of the separately stated and nonseparately computed items of X as provided in § 1366, making any adjustments to basis as provided in § 1367, and taking into account any distributions made by X as provided in § 1368. If X or its shareholders fail to treat themselves as described above, this letter ruling shall be null and void.

This ruling is further conditioned upon the beneficiary of Trust 2 filing, with the appropriate service center, a QSST election for Trust 2. This QSST election must be filed within 120 days following the date of this letter and a copy of this letter should be attached to the election.
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Except as specifically ruled above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provisions of the Code. In particular, we express no opinion on whether Trust 2 is eligible to be a QSST.

This ruling is directed only to the taxpayer that requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

Pursuant to a power of attorney on file, a copy of this letter is being sent to X’s authorized representative.

Sincerely,

Charlotte Chyr
Senior Technician Reviewer, Branch 2
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes