PLR 1223007: IRS preserves S corporation status after QSST and shareholder errors

Plain-English summary

The IRS ruled that a corporation's S election terminated when a trust became an ineligible shareholder after a missed QSST election, shares were issued late to other eligible shareholders, and stock was temporarily held by another ineligible shareholder. The IRS found the termination and related failures inadvertent and allowed the corporation to continue being treated as an S corporation, provided the beneficiary filed the QSST election within 120 days and the S election was not otherwise terminated. The ruling also preserved S corporation treatment for the later period during which the ineligible shareholder held the stock. Shareholders must continue to report pass-through items, adjust stock basis, and account for distributions under §§ 1366 through 1368.

Ruling snapshot

• Question: Could the corporation retain S corporation treatment after the trust and shareholder eligibility failures?
• Outcome: Approved, contingent on the QSST election and the corporation's continued eligibility.
• 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: 201223007 Third Party Communication: None
Release Date: 6/8/2012 Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.02-03
Person To Contact:
------------------------------- --------------, ID No. -----------------
-------------------------------------------------- Telephone Number:
--------------------------------------------- ---------------------
---------------------------------------------- Refer Reply To:
CC:PSI:B01
PLR-135801-11
Date:
February 23, 2012

LEGEND

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

Y = -------------------------

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

B = ----------------------------

C = --------------------------

D = --------------------------

E = -----------------------

F = -------------------------
--------------------------------------------

Trust 1 = ---------------------------------------------------------------
PLR-135801-11 2

Trust B = -----------------------------------------------------------------------------------------

                       -----------------------------------------------------------------------------
                       -------------------------

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

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

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

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

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

Date 6 = --------------------------

Year = -------

State = ----------

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

This responds to a letter dated August 15, 2011, submitted on behalf of X by X’s
authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue
Code.

FACTS

According to the information submitted, X was incorporated on Date 1, under the laws of
State. Effective Year, X elected to be taxed as an S corporation.

A, a shareholder of X, transferred her X shares to Trust 1. Trust 1 was a grantor trust
and an eligible shareholder of X under §1361(c)(2)(A)(i). On Date 2, A died. After A’s
death, Trust 1 continued to hold the X shares and continued to be an eligible
shareholder of X under § 1361(c)(2)(A)(ii) until Date 3.

Under the terms of Trust 1, upon A’s death Trust 1 was to be divided into new separate
trusts. The X shares were to be held by Trust B and another trust. Trust B was
intended to be treated as a qualified subchapter S trust (QSST) effective Date 3
however, B, the beneficiary of Trust B did not file a timely election to treat Trust B as a
QSST as of Date 3 and the shares of X to be held by Trust B were not issued to Trust B
PLR-135801-11 3

until Date 4. The X shares that were to be held by the other trust were instead issued
by X to C and D on Date 4. C and D are individuals and eligible shareholders.

On Date 5, E transferred her shares of X to Y. Y is an ineligible shareholder of X. On
Date 6, F acquired the shares of X that E transferred to Y. During the period that Y held
shares of X, Y and X both treated Y as a shareholder of X with respect to the shares
held by Y.

X represents that Trust B qualified as a QSST under § 1361(d) as of Date 4 and
thereafter.

X represents that the circumstances resulting in the failure to file a timely QSST
election for Trust B, the failure to timely issue the X shares to C and D, and the sale of
the X stock to Y was inadvertent and was not motivated by tax avoidance or retroactive
tax planning. X and its shareholders have agreed to make such adjustments
(consistent with the treatment of X as an S corporation) as may be required by the
Secretary.

LAW AND ANALYSIS

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) defines a “small business corporation” as 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 1
class of stock.

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) as owned by an individual who is a citizen or resident
of the United States may be a shareholder.

Section 1362(c)(2)(A)(ii) provides that a trust which was described in § 1361(c)(2)(A)(i)
immediately before the death of the deemed owner and which continues in existence
after such death, but only for the 2-year period beginning on the day of the deemed
owner's death may be a shareholder.

Section 1361(d)(1) provides that a QSST whose beneficiary makes an election under
§ 1362(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the QSST’s
beneficiary will be treated as the owner (for purposes of § 678(a)) of that portion of the
QSST’s S corporation stock to which the election under § 1361(d)(2) applies. Under
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§ 1361(d)(2)(A), a beneficiary of a QSST may elect to have § 1361(d) apply. Under
§ 1361(d)(2)(D), this election will be effective up to 15 days and two months before the
date of the election.

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); (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 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 such corporation at any time during the period
specified pursuant to § 1362(f), agrees to make the adjustments (consistent with the
treatment of such 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, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 3 as a result of Trust 1 becoming an
ineligible shareholder. We further conclude that the termination of X’s S election on
Date 3 was inadvertent within the meaning of § 1362(f). Pursuant to the provisions of
§ 1362(f), X will be treated as continuing to be an S corporation as of Date 3 and
thereafter, provided that B files a QSST election for Trust B effective Date 4 with the
appropriate service center within 120 days from the date of this letter, and X's S
corporation election is not otherwise terminated under § 1362(d). A copy of this letter
must be attached to the QSST election.

It is further concluded that X will be treated as continuing to be an S corporation during
the period of Date 5 to Date 6, and for subsequent periods, unless X’s S corporation
election is otherwise terminated under the provisions of section 1362(d).

Accordingly, X’s shareholders, in determining their respective income tax liabilities, must
include their pro rata share of the separately and non-separately computed items of X
as provided in § 1366, make any adjustments to stock basis as provided in § 1367, and
take into account distributions made by X as of provided by § 1368.

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.
PLR-135801-11 5

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.

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to X’s authorized representative.

                                  Sincerely,


                                  Faith Colson
                                  Faith Colson
                                  Senior Counsel, Branch 1
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

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