PLR 201203002: Inadvertent S corporation termination is cured after an ineligible shareholder transfer

Plain-English summary

A corporation's S election terminated when it issued shares to an ineligible shareholder. The corporation promptly distributed those shares to eligible S corporation shareholders after discovering the mistake, and it continued to treat itself as an S corporation. The IRS ruled that the termination was inadvertent and that the corporation would be treated as an S corporation from the termination date onward, provided its election was otherwise valid and did not later terminate.

Ruling snapshot

• Question: Can a corporation retain S corporation treatment after issuing shares to an ineligible shareholder by mistake?
• Outcome: Approved
• Key authorities: IRC §§ 1361 and 1362

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201203002
Third Party Communication: None
Release Date: 1/20/2012
Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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Refer Reply To:
CC:PSI:B02
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Date:
September 28, 2011

Legend

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

A = ---------------------------------------------------------------------------------------------------

State = ----------------
Year 1 = ---------
Date 1 = --------------------------

Date 2 = ----------------------
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Dear ---------------:

This letter responds to a letter dated March 18, 2011, and subsequent correspondence, submitted by X's authorized representative on behalf of X, requesting inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

The information submitted states that X was formed under the laws of State in Year 1 and elected to be treated as an S corporation effective Year 1. Effective Date 1, X issued shares of X to A, a limited liability company and an ineligible S corporation shareholder under § 1361(b)(1)(B). X represents that upon discovery of its error, it promptly took remedial action. Effective Date 2, all of the X shares held by A were distributed to eligible S corporation shareholders.

X represents that the transfer X of stock to A, an ineligible shareholder, was not motivated by tax avoidance or retroactive tax planning. X and its shareholders have continued to treat X as an S corporation at all times. X and its shareholders agree to
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make any adjustments (consistent with the treatment of X as an S corporation) that the Secretary may require.

Section 1361(a)(1) of the Code defines an “S corporation” as 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 1362(d)(2) provides that an election under § 1362(a) shall be terminated whenever (at any time on or after the first day of the taxable year for which a corporation is an S corporation) such corporation ceases to be a small business corporation. A termination of an S corporation election under § 1362(d)(2) is 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 paragraph (2) or (3) of § 1362(d), (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 is a small business corporation, or (B) to acquire the required 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 such ineffectiveness or termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Based solely on the information submitted and the representations made, we conclude that X's S corporation election terminated on Date 1, when X issued X stock to A, an ineligible shareholder. We also conclude that this termination was inadvertent within the meaning of § 1362(f), and that under the provisions of § 1362(f), X will be treated as an S corporation from Date 1, and thereafter, provided that X's S election was valid and was not otherwise terminated.

Except as specifically ruled upon above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provisions of the Code. Specifically, no opinion is expressed on whether X was otherwise eligible to be treated as an S corporation.
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This ruling is directed only to the taxpayer who requested it. Section § 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

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

Sincerely,

Melissa C. Liquerman
Chief, Branch 2
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures: (2)