Ineligible shareholder caused an inadvertent S election termination

Plain-English summary

An S corporation's election terminated when an ineligible shareholder acquired its stock. The corporation corrected the problem by having that shareholder distribute the shares to eligible shareholders. The IRS accepted the representation that the termination was inadvertent and was not motivated by tax avoidance or retroactive tax planning. Under § 1362(f), the corporation would continue to be treated as an S corporation from the termination date, provided its election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Could the corporation receive inadvertent-termination relief after an ineligible shareholder acquired its stock?
• Outcome: Approved
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201418045
Third Party Communication: None
Release Date: 5/2/2014
Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00,
1362.01-00
Person To Contact:
-----------------, ID No. -------------- ------------------------------------------------ Telephone Number:
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Refer Reply To:
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CC:PSI:B01
PLR-144464-13
Date:
January 23, 2014

Legend

X = -----------------------------------------------
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Y = -----------------------------
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Date 1 = ------------------

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

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

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

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

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

This responds to a letter dated August 19, 2013 submitted on behalf of X, by X’s authorized representative, requesting relief under § 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted, X was incorporated under the laws of State on Date 1 and elected to be an S corporation effective Date 2. X’s election was terminated effective Date 3 when Y, an ineligible shareholder, became an owner of X
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stock. X represents that it has taken corrective action on Date 4 by having Y distribute X’s shares to eligible shareholders.

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 have agreed to make the 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) 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) defines a “small business corporation” as 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 1 class of stock.

Section 1362(d)(2) states that (A) in general, 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 (B) any termination under § 1362(d)(2) shall be effective on and after the date of cessation.

Section 1362(f) provides, in relevant 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); (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 (A) so that the corporation for which the election was made or the termination occurred is a small business corporation, or (B) to acquire the required shareholder consents; and (4) the corporation for which the election was made or 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 the 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 ineffectiveness or termination, such
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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 S corporation election was terminated on Date 3 because Y was an ineligible shareholder of X. We further conclude that the termination of X’s S corporation election constituted an inadvertent termination within the meaning of § 1362(f). Under 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).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, we express or imply no opinion regarding whether X is otherwise eligible to be treated as an S corporation. Further, we express or imply no opinion regarding the federal tax treatment of Y’s distribution of X’s shares.

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, we are sending a copy of this letter to your authorized representative.

Sincerely,

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

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

cc: