Defective trust terms receive inadvertent S corporation termination relief

Plain-English summary

An individual transferred S corporation stock to a grantor trust that later terminated and divided the stock between two successor trusts. The parties filed QSST elections for those trusts, but the governing terms did not actually satisfy the qualified subchapter S trust requirements. A state court later approved an amendment intended to create new separate trusts with valid QSST provisions. The corporation and shareholders had consistently reported S corporation treatment, administered the defective trusts as QSSTs, and represented that the failure was inadvertent rather than tax-motivated. The IRS granted relief under section 1362(f), conditioned on moving the shares to the new trusts and filing QSST elections for them within 120 days of the ruling.

Ruling snapshot

• Question: Can the corporation retain S status after stock passed to trusts whose terms did not qualify them as QSSTs?
• Outcome: Approved
• Key authorities: IRC §§ 643(b), 678(a), 1361(d), 1362(f); Rev. Rul. 93-79

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201528020                                             Third Party Communication: None
Release Date: 7/10/2015                                       Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.03-02
                                                              Person To Contact:
------------------------------------------                    ------------------------------ ------------
------------------                                            Telephone Number:
-----------------------------                                 --------------------
---------                                                     Refer Reply To:
 --------------------------                                   CC:PSI:B01
                                                              PLR-137925-14
                                                              Date:
                                                              April 07, 2015




LEGEND:

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

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

Trust 1             =       ----------------------------------------------------------------------------------------------------
                            ------------------------------------

Trust 2             =       ----------------------------------------------------------------------------------------------------
                            ----------------------------------------------------------------------------------------------------
                            ----------------------------------------------------------------------------------------------------
Trust 3                     ------------------------------------------------------------------------------
                            ---------------------

State               =       ---------

Court               =       -------------------------------------

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

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

Date 3              =       ----------------
                            ----------------------------------------------------------------------------------------------------
Date 4              =       ------------------------------
                            ----------------------------------------------------------------------------------------------------
Date 5              =       ----------------------------------
PLR-137925-14                                2



Dear-------------

        This responds to a letter dated September 29, 2014, submitted on behalf of X by
its authorized representative, requesting a ruling under § 1362(f) of the Internal
Revenue Code

Facts

       The information submitted states that X was incorporated under the laws of State
on Date 1. Effective Date 2, X elected to be taxed as an S corporation. At the time of
the election, A, an individual, held shares of X.

        On Date 3, A transferred shares of X to Trust 1. Trust 1 was treated as an
eligible shareholder of X under § 1361(c)(2)(A)(i). Pursuant to its terms, Trust 1
terminated on Date 4. Upon termination, Trust 1 provided that the entire remaining
balance of Trust 1 including the X stock was to be divided into two and distributed to two
trusts, Trust 2 and Trust 3. Trust 2 and Trust 3 were to be administered as provided in
Trust 1’s governing document. It was believed that Trust 2 and Trust 3 met the
requirements of qualified subchapter S Trusts (QSSTs) under § 1361(d)(3) and QSST
elections were filed for them as of Date 4. However, neither Trust 2 or Trust 3 was a
valid QSST because their terms did not meet the requirements of § 1361(d)(3).

       On Date 5, Court of State approved a petition to amend the governing document
of Trust 1 ab initio to provide that, to the extent that X stock would otherwise be held by
Trust 2 and Trust 3, the X stock would instead be held by separate trusts with provisions
generally identical to those of Trust 2 and Trust 3 except that the new separate trusts
(New Trusts) would include provisions to qualify New Trusts as QSSTs under
§ 1361(d)(3).

       X represents that at all relevant times, X and its shareholders treated X as an S
corporation. X represents that Trust 2 and Trust 3 have been administered as though
the trusts were QSSTs since Date 4. X further represents that the termination of X’s S
election was inadvertent and was not motivated by tax avoidance or retroactive tax
planning. X and its shareholders have agreed to make any adjustments (consistent with
the treatment of X as an S corporation) as may be required by the Secretary.

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.
PLR-137925-14                                 3

      Section 1361(b)(1)(B) provides that a “small business corporation” means a
domestic corporation that is not an ineligible corporation and that does not 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.

       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(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)(3) defines a QSST as a trust (A) the terms of which require that
(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust; (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary; (iii) the income interest of the
current income beneficiary in the trust shall terminate on the earlier of the beneficiary’s
death or the termination of the trust; and (iv) upon the termination of the trust during the
life of the current income beneficiary; the trust shall distribute all of its assets to that
beneficiary; and (B) all of the income (within the meaning of § 643(b)) of which is
distributed (or required to be distributed) currently to one individual who is a citizen or
resident of the United States.

        Section 1362(f) provides 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 the
termination, steps were taken so that the corporation is a small business corporation;
and (4) the corporation, and each person who was a shareholder of the corporation at
any time during the period specified under § 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 for that 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.

        Rev. Rul. 93-79, 1993-2 C.B. 269, provides that a state court order that reforms a
trust to meet the requirements of a QSST is recognized prospectively.

Conclusion
PLR-137925-14                                 4

       Based solely on the information submitted and the representations made, we
conclude that X’s S corporation election terminated on Date 4 when the X stock was
transferred to Trust 2 and Trust 3 because Trust 2 and Trust 3 were ineligible
shareholders of X. We further conclude that the termination of X’s S corporation
election constituted an inadvertent termination within the meaning of § 1362(f).
Accordingly, pursuant to the provisions of § 1362(f), X will be treated as an S
corporation from Date 4 and thereafter, provided that X’s S corporation election was
otherwise valid and has not otherwise terminated under § 1362(d).

        This ruling is conditioned upon the X stock held by Trust 2 and Trust 3 being
transferred to New Trusts and New Trusts filing QSST elections effective the date of the
X stock transfer, 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 elections.

       Except as specifically ruled above, we express or imply no opinion concerning
the federal tax consequences of the transactions described above under any other
provision of the Code. Specifically, we express or imply no opinion regarding whether X
is otherwise eligible to be an S corporation. This ruling is directed only to the taxpayer
who requested it.

       Section 6110(k)(3) provides that it may not be used or cited as precedent. In
accordance with the power of attorney on file with this office, a copy of this letter is
being sent to X’s authorized representative.


                                       Sincerely,


                                       Faith P. Colson
                                       Faith P. Colson
                                       Senior Counsel, Branch 1
                                       (Passthroughs & Special Industries)



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



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