PLR 1225005: 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