Corporation receives relief for inadvertent S election termination

Plain-English summary

An S corporation transferred shares to two ineligible shareholders, which terminated its S election. The corporation and its shareholders did not know that the recipients were prohibited from holding the shares and did not intend to end the election. After discovering the problem, the corporation transferred the shares to eligible shareholders and agreed with its shareholders to make any adjustments required by the IRS. The IRS ruled that the termination was inadvertent under § 1362(f). The corporation will continue to be treated as an S corporation from the termination date forward, provided its election was otherwise valid and was not otherwise terminated.

Ruling snapshot

• Question: Could the corporation retain S corporation treatment after shares were transferred to two ineligible shareholders?
• Outcome: Approved as an inadvertent termination
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201451019 Third Party Communication: None
Release Date: 12/19/2014 Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.01-00
Person To Contact:
------------------------------ -----------------, ID No. ------------------
--------------------------------------------- Telephone Number:
------------------------------------ ----------------------
---------------------------------- Refer Reply To:
CC:PSI:B01
PLR-118339-14
Date:
September 15, 2014

Legend

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

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

B = ------------------------

C = -------------------------------------------------------

D = ------------------

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

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

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

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

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

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

Dear -------------------:
PLR-118339-14 2

   This responds to a letter dated April 30, 2014 submitted on X’s behalf by X’s

authorized representative, requesting relief under § 1362(f) of the Internal Revenue
Code.

FACTS

  According to the information submitted and representations made, X was

incorporated under the laws of State on Date 1 and elected to be treated as an S
corporation effective Date 1.

    X’s S corporation election terminated when it transferred shares of X to A and C,

ineligible shareholders, on Date 2. On Date 3, X discovered that it had terminated its S
corporation election and took corrective action. On Date 4, C’s shares of X were
transferred to D, an eligible shareholder. On Date 5, A’s shares of X were transferred to
B, an eligible shareholder.

   X represents that its shareholders were unaware that A and C were prohibited

from owning shares of X, and that such a transaction would terminate X’s S corporation
election. X also represents that its shareholders did not intend to terminate X’s S
corporation election. In addition, X represents that its S corporation election termination
was not motivated by tax avoidance or retroactive tax planning. Lastly, X and its
shareholders have agreed to make such adjustments, consistent with the treatment of X
as an S corporation, as may be required by the Service.

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) 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 termination under § 1362(d)(2) shall be effective on and after the
date of cessation.
PLR-118339-14 3

   Section 1362(f) provides, in relevant 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
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 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 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 the representations made, we conclude

that X’s S corporation election was terminated on Date 2 when X transferred shares to
A and C, ineligible shareholders. However, we further conclude that the termination
was inadvertent within the meaning of § 1362(f). Therefore, X will be treated as an S
corporation effective Date 2 and thereafter, provided that X’s S corporation election was
otherwise valid and was not otherwise terminated under § 1362(d).

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

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

     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 X’s
eligibility to be an S corporation.

  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-118339-14 4

     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,


                                    Laura C. Fields
                                    Laura C. Fields
                                    Senior Technician Reviewer, Branch 1
                                    Office of the Associate Chief Counsel
                                    (Passthroughs & Special Industries)

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