Late ESBT election does not terminate S corporation status

Plain-English summary

A trust that held S corporation stock ceased to be a grantor trust and became an ineligible shareholder because its trustee did not timely elect electing small business trust status. The corporation and trust continued reporting inconsistently with ESBT treatment, but the corporation agreed to adjustments specified in a separate ruling. The IRS found that the S election termination was inadvertent and allowed the corporation to retain continuous S status. Relief is conditioned on payment of the required adjustment and filing an ESBT election effective on the termination date, both within 120 days. Failure to satisfy either condition makes the ruling void.

Ruling snapshot

• Question: Can the corporation retain S status after its shareholder trust failed to make a timely ESBT election?
• Outcome: Approved, conditioned on the separate adjustment payment and a retroactive ESBT election within 120 days.
• Key authorities: IRC §§ 1361(e) and 1362(f); Treas. Reg. § 1.1361-1(m).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201516002 Third Party Communication: None
Release Date: 4/17/2015 Date of Communication: Not Applicable
Index Number: 1362.02-02, 1362.04-00
Person To Contact:
---------------------------------------- --------------, ID No. ----------------
--------------------------------------------------- Telephone Number:
-------------------- --------------------
------------------------------ Refer Reply To:
CC:PSI:B01
PLR-120421-14
Date:
November 05, 2014

Legend

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

Trust = -----------------------------------

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

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

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

PLR1 = ---------------------

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

This responds to a letter dated May 14, 2014, and supplemental information, submitted
on behalf of X by X’s authorized representative, requesting relief under section 1362(f)
of the Internal Revenue Code (the Code).

FACTS

According to the information submitted and representations within, X was incorporated
on Date 1, under the laws of State. Effective Date 1, X elected to be taxed as an S
corporation. Prior to Date 2, Trust was a grantor trust and as such an eligible
shareholder of X. On Date 2, Trust ceased being a grantor trust. A timely election to
PLR-120421-14 2

treat Trust as an ESBT was not made, thus Trust became an ineligible shareholder of X,
causing X’s S corporation election to terminate effective Date 2.

X represents that Trust has at all times met the requirements of an ESBT within the
meaning of § 1361(e). Throughout the period that Trust has been a shareholder of X, it
did not file its federal income tax returns consistent with being an ESBT; however, X has
agreed to certain adjustments as provided in PLR1. X represents that its S corporation
election termination was inadvertent and was not motivated by tax avoidance or
retroactive tax planning. Further, X represents that X and its shareholders agree to
make any adjustments required as a condition of obtaining relief under the inadvertent
termination rule as provided under § 1362(f) of the Code that may be required by the
Secretary.

LAW AND ANALYSIS

Section 1361(a)(1) of the Code 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 § 1362(b)(1)(B), an electing
small business trust (ESBT) may be an S corporation shareholder.

Section 1361(e) provides that an ESBT 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)(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)(1)(B) provides that the term “electing small business trust” shall not
include (i) any qualified subchapter S trust (as defined in § 1361(d)(3)) if an election
under § 1361(d)(2) applies to any corporation the stock of which is held by such trust,
(ii) any trust exempt from tax under subtitle A, and (iii) any charitable remainder annuity
trust or charitable remainder unitrust (as defined in § 664(d)).

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
PLR-120421-14 3

Secretary.

Section 1.1361-1(m)(2)(i) provides that the trustee of an ESBT must make the ESBT
election by signing and filing, with the service center where the S corporation files its
income tax return, a statement that meets the requirements of § 1.1361-1(m)(2)(ii).

Section 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the ESBT
election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a QSST
election (generally within the 16-day-and-2-month period beginning on the day that the
stock is transferred to the trust).

Section 1362(f) provides, in relevant part, that if (1) an election under § 1362(a) by any
corporation 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
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 for which
the election was made or termination occurred is a small business corporation; and (4)
the corporation for which the election was made or 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 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 election inadvertently terminated within the meaning of § 1362(f) on Date 2 when
Trust became and ineligible shareholder. Pursuant to the provisions of § 1362(f), X will
be treated as an S corporation from Date 2 and thereafter, provided X’s S corporation
election is not otherwise terminated under § 1362(d).

This letter is contingent upon the following conditions: (1) X must fully comply with the
adjustment payment requirement as outlined in PLR1 and said payment shall be sent
no later than 120 days from the date of this letter; (2) within 120 days from the date of
this letter, an election to treat Trust as an ESBT effective Date 2, must be made with the
appropriate service center. A copy of this letter should be attached to the ESBT
election. If these conditions are not met, then this ruling is null and void. Furthermore,
if these conditions are not met, X must send notification that its S election has
terminated to the service center with which X’s S election was filed.
PLR-120421-14 4

Except as specifically ruled upon above, we express or imply no opinion concerning the
federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

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

                                  Sincerely,


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

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

cc: