PLR 201225005: IRS grants relief for an inadvertent S-election termination

Plain-English summary

An S corporation asked for relief after two trusts that were not initially eligible shareholders acquired its stock, and another trust did not currently distribute all of its income to its beneficiary. The IRS concluded that the corporation's S election terminated when the first ineligible trust became a shareholder, but that the termination was inadvertent under IRC § 1362(f). The corporation would be treated as an S corporation during the specified period if the shareholders made the required QSST elections within 120 days and all parties followed the required consistent treatment. The ruling was conditional and would be void if those requirements were not met.

Ruling snapshot

• Question: Could the corporation receive relief for an inadvertent S-election termination caused by trust shareholders?
• Outcome: Approved
• Key authorities: IRC §§ 1361 and 1362; Treas. Reg. § 1.1361-1

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201225005
Third Party Communication: None
Release Date: 6/22/2012
Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.03-02
Person To Contact:
----------------------------------------- -----------, ID No. -----------------
--------------------------------------------------------- Telephone Number:
------------------
---------------------
--------------------------------------
Refer Reply To:
CC:PSI:B01
PLR-139128-11
Date:
March 13, 2012

Legend:

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

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

D1 = ------------------

D2 = ----------------------

D3 = ----------------

Trust A = -----------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
---------
--------------------------------------------------

D4 = ----------------

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

Year 1 = -------

Year 2 = -------
PLR-139128-11
-2-

Year 3 = -------

Trust C = ------------------------------------------
--------------------------------------------------

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

This responds to the letter dated September 15, 2011, and related correspondence, submitted on behalf of X, requesting relief under § 1362(f) of the Internal Revenue Code (ACode@) for an inadvertent termination of X’s S election.

FACTS

The information submitted states that X was organized under the laws of State on D1. X elected to be treated as an S corporation, effective D2. On D3, Trust A, an ineligible S corporation shareholder, became a shareholder of X. On D4, Trust B, also an ineligible S corporation shareholder, became a shareholder of X. Further, in Year 1, Year 2, and Year 3, Trust C, another shareholder of X and a qualified Subchapter S Trust (“QSST”), failed to distribute currently all of its income to the beneficiary of Trust C.

X and its shareholders were unaware that Trust A and Trust B were ineligible shareholders and did not intend the S election of X to terminate. Further, the beneficiaries of Trust A and Trust B were not aware of the necessity of QSST elections and, therefore, did not file the elections on behalf of Trust A and Trust B. In addition, the trustee of Trust C was not aware of the necessity of current distribution of all of its income to the beneficiary of Trust C.

Immediately after the discovery of the error, X and its shareholders took remedial action. Trust C has since distributed all of the income that should have been distributed to the beneficiary of Trust C. In addition, X and its shareholders agree to make any adjustments required by the Commissioner consistent with the treatment of X as an S corporation.

LAW AND ANALYSIS

Section 1361(a)(1) defines an “S corporation” as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.
PLR-139128-11
-3-

Section 1361(b)(1)(B) provides that a small business corporation cannot 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(a) provides that a small business corporation may elect, in accordance with the provisions of § 1362, to be an S corporation.

Section 1361(c)(2)(A)(i) provides that 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(d)(1) provides, in part, that a QSST whose beneficiary makes an election under § 1361(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), thereby an eligible shareholder of an S corporation, 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 §1362(d)(2) applies.

Under § 1361(d)(2)(A), a beneficiary of a QSST (or his legal representative) may elect to have § 1361(d) apply. Under § 1361(d)(2)(D), this section will be effective up to 15 days and 2 months before the date of the election.

Section 1361(d)(3) defines the term Aqualified Subchapter S trust@ as a trust -

(A) the terms of which require that

(i) during the life of the current income beneficiary, there shall be only 1 income beneficiary of the trust, (ii) any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary,
(iii) the income interest of the current income beneficiary in the trust shall terminate on the earlier of such beneficiary=s death or the termination of the trust, and (iv) upon the termination of the trust during the life of the current beneficiary, the trust shall distribute all its assets to such beneficiary, and

(B) all of the income (within the meaning of § 643(b)) of which is distributed (or required to be distributed) currently to 1 individual who is a citizen or resident of the United States.

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 taxable year for which
PLR-139128-11
-4-

the corporation is an S corporation) the corporation ceases to be a small business corporation. The termination is effective on and after the day of cessation.
§1362(d)(2)(B).

Section 1362(f) provides, in part, 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 such 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 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 this subsection, 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, such corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1.1361-1(j)(6)(ii) of the Income Tax Regulations provides that the current income beneficiary of the trust (or his legal representative) must make the QSST election by signing and filing with the service center with which the corporation files its income tax return the applicable form or a statement including the information listed in § 1.1361-1(j)(6)(ii).

Section 1.1361-1(j)(6)(iii)(A) provides that if S corporation stock is transferred to a trust, the QSST election must be made within the 16-day-and-2-month period beginning on the day that the stock is transferred to the trust.

Section 1.1361-1(j)(7)(i) provides that the income beneficiary who makes the QSST election and is treated (for purposes of § 678(a)) as the owner of that portion of the trust that consists of S corporation stock is treated as the shareholder for purposes of §§ 1361(b)(1), 1366, 1367, and 1368.

Section 1.1362-4(d) provides 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.

CONCLUSION

Based solely upon the facts submitted and the representations made, we conclude that X’s S election terminated on D3, when Trust A became a shareholder of
PLR-139128-11
-5-

X. We further conclude that the termination of X’s S election constituted an inadvertent termination within the meaning of § 1362(f).

Under § 1362(f), X will be treated as an S corporation on D3, and thereafter, provided that X’s S election was otherwise valid and has not otherwise terminated under § 1362(d).

This ruling is contingent upon X and all its shareholders treating X as having been an S corporation and Trust A and Trust B as QSSTs for the period beginning D3, and thereafter. Within 120 days from the date of this letter, the beneficiaries (or their legal representatives) of Trust A and Trust B must elect to treat Trust A and Trust B as QSSTs, effective D3 and D4, respectively, with the appropriate service center. A copy of this letter should be attached to each election. If these conditions are not met, then this ruling is null and void.

Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the above-described facts under any other provision of the Code, including whether X was otherwise eligible to be an S corporation, or whether Trust A, Trust B, and Trust C were otherwise eligible to be QSSTs.

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.

In accordance with the Power of Attorney on file with this office, a copy of this letter ruling will be sent to your authorized representative.

Sincerely,

Joy C. Spies
Joy C. Spies
Acting Senior Technician Reviewer
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2)

Copy of this letter
Copy for § 6110 purposes