PLR 1238017: IRS preserves S corporation status after defective trust elections

Plain-English summary

The IRS ruled that a corporation's S election was ineffective at first because several shareholder trusts were not eligible shareholders or had made the wrong type of election. It also ruled that later events involving an ineligible shareholder caused potential terminations, but that all of these problems were inadvertent under IRC § 1362(f). The corporation could therefore be treated as an S corporation from the original effective date onward, assuming its election was otherwise valid and not otherwise terminated. The ruling required the trusts and beneficiary to file specified ESBT and QSST elections, and required the corporation and its current and former shareholders to file consistent original or amended returns. It also required a specified payment and imposed other conditions on the relief.

Ruling snapshot

• Question: Can the corporation retain S corporation status after defective trust elections and later ineligible trust shareholders?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(f), 1366, 1367, and 1368; Treas. Reg. § 1.1362-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201238017 Third Party Communication: None
Release Date: 9/21/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1361.03-00, 1361.03-02, ----------------------, ID No. -----------------
Telephone Number:
1361.03-03, 1362.02-00,
---------------------
1362.04-00 Refer Reply To:
CC:PSI:B01
----------------------------------- PLR-126322-10
------------------------------------ Date:
------------------------------------------ May 29, 2012

Legend

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

Trust1 = ---------------------------------------------------------------------------------------------------
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Trust2 = ---------------------------------------------------------------------------------------------------
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Trust3 = --------------------------------------------------------------------------------------------------

Trust4 = ---------------------------------------------------------------------------------------------------

Trust5 = -----------------------------------------------------------

Trust6 = -----------------------------------------------------------

Trust7 = ---------------------------------------------------------------

Trust8 = -------------------------------------------------------------

Trust9 = -------------------------------------------------------------------

Trust10 = -------------------------------------

Trust11 = -------------------------------------------------------------------------------------

Trust12 = -----------------------------------------------------------------------------

PLR-126322-10 2

Trust13 = -------------------------------------------------------------------------

Trust14 = ---------------------------------------------------------------

Individual1 = --------------------------------

Individual2 = ------------------------

State = ---------
Date1 = ----------------------------
Date2 = ----------------------
Date3 = ------------------------
Date4 = ----------------------
Date5 = ---------------------
Date6 = -------------------
w= ----------------
Year = -------

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

This responds to a letter dated June 21, 2010, and subsequent correspondence,
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 under the laws of State on
Date1. X elected to be an S Corporation effective Date2.

Trust1 – Trust9 each filed an election be treated as a Qualified Subchapter S Trust
(“QSST”), effective Date2. It was subsequently discovered that discovered that Trust1 –
Trust9 were not qualified to make QSST elections but Trust1 – Trust8 were qualified to
make Electing Small Business Trust (“ESBT”) elections. Trust9 included a nonresident
alien as a potential current beneficiary, disqualifying Trust9 from treatment as an ESBT.
X represents that no distributions were made to a nonresident alien beneficiary and that
all shares in X held by Trust9 were redeemed on Date5.

Trust10 was a permitted shareholder on Date2, but inadvertently failed to file a QSST
election effective Date3.

Trust11 and Trust12 filed QSST elections effective Date2 but were not established as
true trusts. Instead, Individual1 and Individual2, the intended beneficiaries of Trust11
and Trust12 respectively, owned the X stock directly and filed federal income tax returns
treating themselves as the owners of the X stock.

PLR-126322-10 3

On Date4, Trust13 and Trust14 became shareholders of X and each filed an election to
be treated as a QSST. Trust13 and Trust14 are eligible to be ESBTs but not QSSTs.

X represents that the failure to make the appropriate ESBT and QSST elections for the
trusts, as well as the other errors and circumstances that led to the possible
ineffectiveness of its S corporation election were inadvertent and not motivated by tax
avoidance or retroactive tax planning. In addition, X and X’s shareholders agree to
make any adjustments consistent with the treatment of X as an S corporation as may be
required by the Secretary with respect to the period specified by § 1362(f).

                              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.

Section 1361(b)(1) provides that the term “small business corporation” means 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 one 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 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 a shareholder.

Section 1361(c)(2)(A)(v) provides that, for purposes of § 1362(b)(1)(B), an ESBT is a
permitted shareholder of a small business corporation.

Section 1361(d)(1) provides that in the case of a QSST with respect to which a
beneficiary makes an election under § 1361(d)(2), such trust shall be treated as a trust
described in § 1361(c)(2)(A)(i) and, for purposes of § 678(a), the beneficiary of such
trust shall be treated as the owner of that portion of the trust which consists of stock in
an S corporation with respect to which the election under § 1361(d)(2) is made.

Section 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

Section 1362(f) provides, in part, that if (1) an election under § 1362(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 (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 such ineffectiveness or
termination, steps were taken so that the corporation is a small business corporation;
and (4) the corporation and each person who was a shareholder of the corporation at

PLR-126322-10 4

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.

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. In the case of stock held by an ineligible shareholder that causes an
inadvertent termination or invalid election for an S corporation under § 1362(f), the
Commissioner may require the ineligible shareholder to be treated as a shareholder of
the S corporation during the period the ineligible shareholder actually held stock in the
corporation. Moreover, the Commissioner may require protective adjustments that
prevent the loss of any revenue due to the holding of stock by an ineligible shareholder
(for example, a nonresident alien).

                                 CONCLUSION

Based solely on the representations made and the information submitted, we conclude
that X’s S corporation election was ineffective as of Date2 because Trust1 – Trust9
were ineligible shareholders. We conclude that the ineffectiveness of X’s S corporation
election was inadvertent within the meaning of § 1362(f). Further, had X’s election been
effective, X’s election would have terminated on Date3, when Trust10 became an
ineligible shareholder, and on Date4, when X stock was transferred to Trust13 and
Trust14, also ineligible shareholders. We conclude that these subsequent potential
terminations were also inadvertent within the meaning of § 1362(f).

Accordingly, we conclude that, pursuant to the provisions of § 1362(f), X will be treated
as an S corporation from Date2 and thereafter, assuming X’s S election is otherwise
valid and not otherwise terminated under § 1362(d).

We further conclude that the shares held by in X held by Trust11 and Trust12 are to be
treated as held directly by Individual1 and Individual2, respectively, effective Date2.

This ruling is contingent on X and its shareholders treating X as having been an S
corporation for the period beginning Date2 and thereafter. The trustees of Trust1 –
Trust9 must file appropriate ESBT elections effective Date2 with the appropriate service
center within 120 days of the date of this letter. A copy of this letter should be attached
to each ESBT election. The trustees of Trust13 – Trust14 must file appropriate ESBT
elections effective Date4 with the appropriate service center within 120 days of the date
of this letter. A copy of this letter should be attached to each ESBT election. The
beneficiary of Trust10 must file a QSST election effective Date3 with the appropriate
service center within 120 days of the date of this letter. A copy of this letter should be
attached to the QSST election.

PLR-126322-10 5

Further, X and all of its current and former shareholders must file any necessary original
or amended returns for Year and all subsequent years consistent with the relief granted
in this ruling within 120 days of the date of this letter. Accordingly, in determining their
respective income tax, all the shareholders of X must include their pro-rata share of the
separately stated items of income, loss, deduction, or credit and nonseparately
computed items of income and loss of X as provided in § 1366, make adjustments to
basis as provided in § 1367, and take into account any distributions made by X as
provided in § 1368 within 120 days of the date of this letter.

Finally, as an adjustment under § 1362(f)(4), a payment of $w 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 14011, Stop 31, Terri Lackey,
Manual Deposit. This payment must be sent no later than Date6.

Except as specifically ruled upon above, we express or imply no opinion as to the
federal income tax consequences of the facts described above under any other
provision of the Code. In particular, we express or imply no opinion concerning whether
X is otherwise eligible to be an S corporation, whether Trust1 – Trust9 and Trust13 –
Trust14 are eligible to be ESBTs under § 1361(e), or whether Trust 10 is eligible to be a
QSST under § 1361(d).

This ruling is directed only to the taxpayer requesting 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 is
being sent to your authorized representative.

                                               Sincerely,


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

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

cc: