Inadvertent S corporation termination relief granted after an ineligible transfer

Plain-English summary

The IRS granted relief to an S corporation whose election terminated when shares were transferred to an ineligible shareholder. The corporation and its shareholders were unaware that the transfer would terminate the election and promptly corrected the ownership problem after discovering it. The IRS treated the corporation as an S corporation from the termination date onward, provided the election was otherwise valid and had not separately terminated. The former owners of the ineligible shareholder were also required to be treated as directly owning their pro rata share of the corporation's stock during the affected period.

Ruling snapshot

• Question: Can an S corporation receive relief under § 1362(f) after an inadvertent transfer to an ineligible shareholder terminates its election?
• Outcome: Approved.
• Key authorities: IRC §§ 1361(b)(1)(B), 1362(a), 1362(d)(2), 1362(f), 1366, 1367, 1368.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201405007 Third Party Communication: None
Release Date: 1/31/2014 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
Person To Contact:
---------------------------------------- ---------------------, ID No. ------------------
------------------------------------------ Telephone Number:
-------------------------- ----------------------
-------------------------------- Refer Reply To:
CC:PSI:B01
PLR-120722-13
Date:
October 17, 2013

Legend

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

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

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

w = --------

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

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

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

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

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

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

  This responds to a letter dated April 27, 2013, and subsequent correspondence,

submitted on behalf of X by X’s authorized representative, requesting inadvertent S
corporation election termination relief pursuant to § 1362(f) of the Internal Revenue
Code.

Facts

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  X was incorporated under the laws of State on Date 1, and elected to be treated

as an S corporation effective Date 2.

  On Date 3, a shareholder of X transferred w shares of X to A. A is not an eligible

shareholder of an S corporation under § 1361(b)(1)(B). Neither X nor X's shareholders
were aware that the transfer of stock to A would cause X’s S corporation election to be
terminated.

   In Date 4, X learned of the termination of X’s S corporation election due to the

transfer of stock to an ineligible shareholder. As a corrective action, the shares of X
were transferred to A’s owners, all of whom were eligible shareholders.

   X represents that, as of Date 3, the shareholders of X were not aware that A was

prohibited from owning shares of X, and that such a transaction would terminate X’s
S corporation election. X also represents that the shareholders of X did not intend to
terminate X’s S corporation election.

Law

  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 1361(a)(1) 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)(B) provides that, for purposes of subchapter S, the term

"small business corporation" means a domestic corporation which is not an ineligible
corporation and which does not 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) provides that an election under § 1362(a) shall be terminated

whenever (at any time on or after the 1st day of the 1st taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation, and that any termination under § 1362(d)(2) shall be effective on and after
the date of cessation.

  Section 1362(f) provides, in part, that if -- (1) an election under § 1362(a) by any

corporation was terminated under § 1362(d)(2); (2) the Secretary determines that the
circumstances resulting in such termination were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
termination, steps were taken so that the corporation for which the termination occurred

PLR-120722-13 3

is a small business corporation, or to acquire the required shareholder consents; 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 such 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 termination, such
corporation shall be treated as an S corporation during the period specified by the
Secretary.

Conclusion

   Based solely on the information submitted and the representations made, we

conclude that X's S corporation election was terminated for the taxable year beginning
Date 3 because A was an ineligible shareholder. We further conclude that the
termination of X’s S corporation election constituted an inadvertent termination within
the meaning of § 1362(f). Accordingly, pursuant to the provisions of § 1362(f), X will be
treated as an S corporation from Date 3 and thereafter, provided that X's S corporation
election was otherwise valid and has not otherwise terminated under § 1362(d).

  From Date 3 to Date 5, the former owners of A must be treated as directly

owning a pro rata portion of the shares of X that were held by A, in addition to any other
shares in X that they held during such period.

      Accordingly, X’s shareholders, in determining their respective income tax

liabilities, must include their pro rata share of the separately and nonseparately
computed items of X as provided in § 1366, make adjustments to basis as provided in
§ 1367, and take into account any distributions as provided in § 1368.

   Except as specifically ruled above, we express or imply no opinion concerning

the federal tax consequences of the transactions described above under any other
provision of the Code.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

PLR-120722-13 4

   In accordance with a power of attorney on file with this office, a copy of this letter

is being sent to X's authorized representatives.

                                   Sincerely,


                                   David R. Haglund
                                   David R. Haglund
                                   Chief, Branch 1
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

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