Late ESBT election preserves a corporation’s S status

Plain-English summary

A trust purchased stock in an S corporation and was otherwise eligible to be an electing small business trust, but its trustee did not make the required ESBT election. The trust therefore became an ineligible shareholder and terminated the corporation’s S election. The corporation represented that the failure was inadvertent and not driven by tax avoidance or retroactive planning. The IRS granted relief under section 1362(f), conditioned on the trustee filing an ESBT election effective on the stock-acquisition date within 120 days. The corporation, its shareholders, the trust, and its beneficiaries also had to file any necessary amended returns and consistently report the corporation and trust under the required S corporation and ESBT rules.

Ruling snapshot

• Question: Could a corporation retain S status after an otherwise eligible trust failed to make a timely ESBT election?
• Outcome: Approved
• Key authorities: IRC §§ 1361(e) and 1362(f); Treas. Reg. § 1.1362-4(d)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201511014
Third Party Communication: None
Release Date: 3/13/2015
Date of Communication: Not Applicable
Index Number: 1361.03-03, 1362.04-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
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Date:
December 01, 2014

LEGEND

X = -----------------------------------------------------------------------------------------------------
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Trust = -----------------------------------------------------------------------------------------------------
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State = -------------------

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

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

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

This letter responds to a letter dated May 30, 2014, 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

X was incorporated under the laws of State on Date 1. X also made an S corporation election effective Date 1. On Date 2, shares of X's stock were purchased by Trust. X represents that Trust was qualified to be an Electing Small Business Trust (ESBT) within the meaning of § 1361(e), however, no election was made under § 1361(e)(3) to treat Trust as an ESBT. Consequently, Trust was an ineligible shareholder and, as a result, X's S corporation election was terminated.
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X represents that the circumstances resulting in the termination of X's S corporation election were inadvertent and not motivated by tax avoidance or retroactive tax planning. 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) 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 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT is a permissible shareholder.

Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), the term “electing small business trust” means any trust if (i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in § 170(c)(2) through (5), or (IV) an organization described in § 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary, (ii) no interest in such trust was acquired by purchase, and (iii) an election under § 1361(e) applies to such trust.

Section 1361(e)(3) provides that an election under § 1361(e) shall be made by the trustee. Any such election shall apply to the taxable year of the trust for which made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

Section 1362(d)(2)(A) 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.

Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a) by any corporation was terminated under § 1362(d)(2) or (3); (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
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occurred is a small business corporation; and (4) the corporation for which the termination occurred, and each person who was a shareholder of the corporation at any time during the period specified pursuant to § 1362(f), agrees to make the adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to this period, then, notwithstanding the circumstances resulting in such termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

Section 1.1362-4(d) of the Income Tax Regulations provides, in pertinent part, 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.

CONCLUSION

Based solely on the information submitted and the representations made, we conclude that X's S corporation election terminated on Date 2 because X had an ineligible shareholder. We further conclude that the termination was inadvertent within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation from Date 2, and thereafter, provided that X’s S corporation election was otherwise valid and has not otherwise terminated under § 1362(d), so long as the trustee of Trust files an ESBT election effective Date 2 with the appropriate service center within 120 days of the date of this letter. A copy of this letter should be attached to the ESBT election.

Accordingly, the shareholders of X must include in their income their pro rata share of the separately and nonseparately computed items of X as provided in § 1366, make any adjustments to stock basis as provided in § 1367, and take into account any distributions made by X to its shareholders as provided in § 1368. This ruling is contingent upon X and each of its shareholders filing, within 120 days of the date of this letter, any amended returns making such adjustments that are necessary to properly reflect the reporting of X’s items of S corporation income. Specifically, Trust and its beneficiaries must file amended returns and make adjustments that are necessary to properly reflect the treatment of Trust as an ESBT and partial § 678(a) trust. A copy of this letter must be attached to any income tax return to which it is relevant.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Except as specifically ruled above, we express or imply no opinion concerning the federal tax consequences of the facts described above under any other provisions
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of the Code, including X’s eligibility to be a valid S corporation, or Trust’s eligibility to be an ESBT.

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.

In accordance with a power of attorney on file with this office, we are sending a copy of this letter to your authorized representative.

Sincerely,

/s/

Holly Porter
Chief, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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