PLR 1228025: IRS restores S corporation status after inadvertent termination

Plain-English summary

An S corporation issued stock to a partnership and a corporation, making those shareholders ineligible for S corporation status. The corporation later redeemed the partnership's shares and replaced the corporation's shares with shares held by its principals. The IRS concluded that the S election terminated when the ineligible shareholders received stock, but that the termination was inadvertent. It allowed the corporation to be treated as continuing to be an S corporation, subject to shareholder reporting, basis, distribution, and payment conditions.

Ruling snapshot

• Question: Could the corporation continue to be treated as an S corporation after an inadvertent termination caused by ineligible shareholders?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(d)(2), and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201228025 Third Party Communication: None
Release Date: 7/13/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1362.04-00 --------------------------, ID No. -------------
Telephone Number:
--------------------
-------------------------- Refer Reply To:
-------------------------------------------------------- CC:PSI:B01
------------------ PLR-146403-11
------------------------ Date
April 10, 2012

LEGEND

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

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

Z = --------------------------------------------------------

State = --------

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

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

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

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

Year = -------

n = ------ -------------

Dear ----. --------:
PLR-146403-11 2

This letter responds to a letter dated November 3, 2011, submitted on behalf of X by its
authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code.
FACTS
The information submitted states that X was incorporated under the laws of State on
Date 1. X elected to be an S corporation effective the same date.
On Date 2, X issued shares of stock to Y, a partnership for federal tax purposes, and Z,
a corporation for federal tax purposes. In year, X redeemed the stock held by Y. Later, a
third party interested in acquiring X concluded that X’s S corporation status terminated
as a result of X’s issuance of stock to Y and Z. On Date 3, X cancelled the shares it had
issued to Z and issued replacement shares to the principals of Z. During the period that
Z held the stock, both Z and X filed their federal income tax returns consistent with Z
being treated as a shareholder of X.
X 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 and its shareholders agree to make any adjustments required by the
Secretary consistent with the treatment of X as an S corporation.
LAW
Section 1361(a)(1) 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 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(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 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 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)) by reason of a failure to meet the requirements of § 1361(b) or to obtain
shareholder consent, 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 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
PLR-146403-11 3

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 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 representations made, we conclude that X's
election to be treated as an S corporation terminated on Date 2, when X issued stock to
ineligible shareholders, Y and Z. We further conclude that the termination constituted an
inadvertent termination within the meaning of § 1362(f).
X will be treated as continuing to be an S corporation on and after Date 2, provided that
X’s S corporation election is not otherwise terminated under § 1362(d). Z will be treated
as a shareholder from Date 2 until Date 3, when the principals of Z became the
shareholders of X.
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.
As an adjustment under § 1362(f)(4), a payment of $n and a copy of this letter must be
sent to the following address: Internal Revenue Service, Cincinnati Service Center, 201
West Rivercenter Blvd., Covington, KY 41001, Stop 31, Terri Lackey, Manual Deposit.
This payment must be sent no later than Date 4.
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 a valid S corporation.

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 will be sent
to X's authorized representative.

                                     Sincerely,


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

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