S corporation receives relief for missed trust elections

Plain-English summary

An S corporation's stock was transferred to a trust that qualified first as a qualified subchapter S trust and later as an electing small business trust, but the required elections were not filed on time. The IRS treated the resulting S election termination as inadvertent and allowed the corporation to continue as an S corporation. Relief required late QSST and ESBT elections within 120 days, amended trust returns and adjustments, and a specified payment. The corporation had also made disproportionate distributions, but the IRS ruled that those timing differences did not create a second class of stock because the governing documents gave all shares identical distribution and liquidation rights.

Ruling snapshot

• Question: Can the corporation retain S status despite missed QSST and ESBT elections and disproportionate distributions?
• Outcome: Approved, subject to late elections, return adjustments, and a required payment.
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. § 1.1361-1.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201527009 Third Party Communication: None
Release Date: 7/2/2015 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------ --------------------------, ID No. ----------------
--------------------------------------------------- -----------------
-------------------------------------------------- Telephone Number:
----------------------------------- ----------------------
Refer Reply To:
CC:PSI:B03
PLR-128711-14
Date:
January 22, 2015

Legend

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

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

D1 = -------------------

D2 = -------------------

D3 = --------------------

D4 = ------------------------

D5 = ------------------------

D6 = --------------------

Period1 = ----------------

Period2 = -------

Shareholder = -------------------------------

Income Beneficiary = ---------------------------------------------------------------------------------
-------------------------------------------------------------

Trust1 = ---------------------------------------------------------------

Trust2 = ---------------------------------------------------------------------------------
---------------------------------------------------------------------------------

PLR-128711-14 2

                           ---------------------------------------------------------------------------------
                           -------------------------

Years = ------------------------------

n = ----------------

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

   This letter responds to a letter dated July 25, 2014, and subsequent

correspondence submitted on behalf of X by its authorized representative, requesting a
ruling under § 1362(f) of the Internal Revenue Code (Code).

                                               FACTS

    The information submitted states that X was organized under the laws of State

on D1 and elected to be an S corporation effective D1. Shareholder transferred shares
in X to Trust1 on D2. Shareholder died on D3. On D4, Trust1 transferred the shares in
X to Trust2 for the benefit of Income Beneficiary. On D5, Income Beneficiary died.

    During the years between D4 and D5, X represents that Trust2 was eligible to be

a qualified subchapter S trust (QSST) within the meaning of § 1361(d), but the Income
Beneficiary did not timely file a QSST election. X also represents that Trust2 was
eligible to be an electing small business trust (ESBT) within the meaning of § 1361(e)
on D5 and thereafter, but the trustee did not timely file an ESBT election. Therefore, on
D4, X’s S corporation election terminated.

   X represents that the termination was not motivated by tax avoidance or

retroactive tax planning. X further represents that it has filed consistently as an S
corporation since D1. X and its shareholders have agreed to make any adjustments
that the Commissioner may require, consistent with the treatment of X as an S
corporation.

    Finally, during Period1, X made disproportionate distributions to one of its

shareholders. X represents that under State law, all of X's stock has identical rights to
distribution and liquidation proceeds. No provision in X's articles of incorporation,
bylaws, or any other governing instruments altered those rights. X further represents
that there is no agreement, written or oral, that any shareholder would be entitled to a
preference regarding X's distribution or liquidation proceeds. X represents that during
Period 2, corrective measures were taken to eliminate the cumulative amount of the
disproportionate distributions.

                                      LAW AND ANALYSIS

PLR-128711-14 3

  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) provides that the term “small business corporation” means 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 one class of stock.

   Section 1361(c)(2)(A)(i) provides that for purposes of § 1361(b)(1)(B), a trust all

of which is treated (under subpart E of part 1 of subchapter J of Chapter 1) as owned by
an individual who is a citizen or resident of the United States may be a shareholder.

 Section 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B) an ESBT

may be a shareholder.

   Section 1361(d)(1) provides that a QSST whose beneficiary makes an election

under § 1361(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the
beneficiary of such trust shall be treated as the owner (for purposes of § 678(a)) of that
portion of the trust which consists of stock in an S corporation with respect to which the
election under § 1361(d)(2) is made.

   Section 1361(d)(2)(A) provides that a beneficiary of a QSST (or his legal

representative) may elect to have § 1361(d) apply. Section 1361(d)(2)(D) provides that
an election under § 1361(d)(2) shall be effective up to 15 days and 2 months before the
date of the election.

    Section 1.1361-1(j)(6)(ii) of the Income Tax Regulations provides that the current

income beneficiary of the trust must make the election under § 1361(d)(2) by signing
and filing with the service center where the corporation files its income tax return the
applicable form or a statement including the information listed in § 1.1361-1(j)(6)(ii).

   Section 1361(e) defines an ESBT. Section 1361(e)(1)(A) provides that, except as

provided in § 1361(e)(1)(B), 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)(2), (3), (4), or (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,

PLR-128711-14 4

(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.

    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 1362(d)(2)(A) provides that an election under § 1362(a) will be

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

    Section 1362(f) provides that if (1) an election under § 1362(a) or

§ 1361(b)(3)(B)(ii) 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) or (3) or § 1361(b)(3)(C), (2) the Secretary determines that the
circumstances resulting in the ineffectiveness or termination were inadvertent, (3) no
later than a reasonable period of time after discovery of the circumstances resulting in
the 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 a
qualified subchapter S subsidiary (QSub), as the case may be, or (B) to acquire the
shareholder consents, and (4) the corporation for which the election was made or 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 such adjustments
(consistent with the treatment of the corporation as an S corporation or a QSub, as the
case may be) as may be required by the Secretary with respect to such period, then,
notwithstanding the circumstances resulting in the ineffectiveness or termination, the
corporation will be treated as an S corporation or a QSub, as the case may be during
the period specified by the Secretary.

   Section 1.1361-1(l)(1) provides, in part, that a corporation that has more than one

class of stock does not qualify as a small business corporation. Except as provided in
§ 1.1361-1(l)(4) (relating to instruments, obligations, or arrangements treated as a
second class of stock), a corporation is treated as having only one class of stock if all
outstanding shares of stock of the corporation confer identical rights to distribution and
liquidation proceeds. Differences in voting stock among shares of stock of a corporation
are disregarded in determining whether a corporation has more than one class of stock.

  Section 1.1361-1(l)(2)(i) provides, in part, that the determination of whether all

outstanding shares of stock confer identical rights to distribution and liquidation
proceeds is made based on the corporate charter, articles of incorporation, bylaws,

PLR-128711-14 5

applicable state law, and binding agreements relating to distribution and liquidation
proceeds (collectively, the governing provisions). Although a corporation is not treated
as having more than one class of stock so long as the governing provisions provide for
identical distribution and liquidation rights, any distributions (including actual,
constructive, or deemed distributions) that differ in timing or amount are to be given
appropriate tax effect in accordance with the facts and circumstances.

    In § 1.1361-1(l)(2)(vi), Example 2 (Distributions that differ in timing), S, a

corporation, has two equal shareholders, A and B. Under S’s bylaws, A and B are
entitled to equal distributions. S distributes $50,000 to A in the current year, but does
not distribute $50,000 to B until one year later. The circumstances indicate that the
difference in timing did not occur by a binding agreement relating to distribution or
liquidation proceeds. The example concludes that under § 1.1361-1(l)(2)(i), the
difference in timing of the distributions to A and B does not cause S to be treated as
having more than one class of stock. However, § 7872 or other recharacterization
principles may apply to determine the appropriate tax consequences.

                                   CONCLUSION

   Based solely on the facts submitted and the representations made, we conclude

that X’s S corporation election terminated on D4 when X had an ineligible shareholder.
In addition, had X’s S corporation election not terminated on D4, it would have
terminated on D5. We conclude that the circumstances resulting in the termination were
inadvertent within the meaning of § 1362(f). Accordingly, under § 1362(f), X will be
treated as an S corporation from D4 and thereafter, provided X’s S corporation election
was otherwise valid and has not otherwise terminated under § 1362(d) for reasons not
addressed in this letter.

   This ruling is conditioned on 1) the estate of Income Beneficiary filing, on behalf

of Income Beneficiary, a QSST election for Trust2, effective D4, with the appropriate
service center within 120 days of the date of this letter, and 2) the trustee of Trust2 filing
an ESBT election, effective D5, with the appropriate service center within 120 days of
the date of this letter. A copy of this letter should be attached to the QSST and ESBT
elections.

  In addition, this ruling is conditioned on Trust2 filing any amended returns and

making adjustments that are necessary to properly reflect the treatment of Trust2 as an
ESBT for Years taxable years.

    Furthermore, as an adjustment under § 1362(f), a payment of $n and a copy of

this letter ruling must be sent to the following address: Internal Revenue Service,
Cincinnati Service Center, 201 West Rivercenter Blvd., Covington, KY 41011, Stop 31,
Terri Lackey, Manual Deposit. The payment and a copy of this letter must be sent no
later than D6.

PLR-128711-14 6

   If all of the above conditions are not met, then this ruling is null and void.

Furthermore, if these conditions are not met, X must send a notification that its S
corporation election has terminated to the service center with which X’s S corporation
election was filed.

    Moreover, based solely on the facts submitted and representations made, we

conclude that because X has identical distribution and liquidation rights under its
governing provisions, the difference in timing between X's disproportionate distributions
and the corrective measures made do not cause X to be treated as having more than
one class of stock for purposes of § 1361(b)(1)(D). However, X's disproportionate
distributions and the corrective measures must be given appropriate tax effect. Under
these circumstances, we conclude that X's S corporation election did not terminate as a
result of the disproportionate distributions and the corrective measures made.

   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
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 that requested it. Section 6110(k)(3)

of the Code 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 X’s authorized representative.

                                      Sincerely,



                                      Mary Beth Carchia
                                      Senior Technician Reviewer, Branch 3
                                      Office of the Associate Chief Counsel
                                      (Passthroughs and Special Industries)

Enclosures (2):

   Copy of this letter
   Copy for § 6110 purposes