Invalid S corporation and QSub elections receive inadvertence relief

Plain-English summary

A corporation's S election was ineffective because one trust did not provide the proper shareholder consents and another trust failed to make an electing small business trust election. Those defects also made a subsidiary's qualified subchapter S subsidiary election ineffective. The IRS found that the invalid elections were inadvertent and ruled that both entities would receive their intended tax status from the original effective date. Relief required consistent returns and written consents from two trust-share owners within 120 days.

Ruling snapshot

• Question: May the corporation and subsidiary be treated as an S corporation and QSub despite trust-shareholder consent and eligibility defects?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362(f); Treas. Reg. §§ 1.1361-1(m), 1.1362-6(b)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201537001 Third Party Communication: None
Release Date: 9/11/2015 Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.01-00,
1362.04-00 Person To Contact:
-----------------------, ID No. -------------------
---------------------------- ---------------------------------------------------
---------------------------------------- Telephone Number:
----------------------------- ----------------------
------------------------------------- Refer Reply To:
CC:PSI:B03
PLR-103314-15
Date:
May 20, 2015

                                               LEGEND

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

Y = ----------------------------------------------------------------------------------------------
---------------------------------

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

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

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

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

State 1 = ----------

State 2 = --------------

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

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

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

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

Date 5 = --------------------------
PLR-103314-15 2

Year = -------

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

This responds to a letter dated December 30, 2014, and subsequent correspondence
on behalf of X by X’s authorized representative, requesting a ruling under § 1362(f) of
the Internal Revenue Code.

                                       FACTS

The information submitted states that Y incorporated in State 1 on Date 1. X
incorporated in State 2 on Date 2. X represents that the shareholders of Y exchanged
their shares in Y for the shares of X in a tax-free exchange. X made an election to be
treated as an S corporation effective Date 3. Also effective Date 3, X elected to treat Y
as a qualified subchapter S subsidiary (QSub). However, Trust 1, one of X’s
shareholders, failed to consent properly to X’s S corporation election. The trustee of
Trust 1, a trust the separate shares of which each qualified as an eligible shareholder
under § 1361(c)(2)(A)(i), and not A and B, the owners of the separate shares of Trust 1,
executed X’s Form 2553, Election by a Small Business Corporation, on behalf of Trust

1. Therefore, Trust 1 did not consent properly to X’s S corporation election.
   Accordingly, X’s S corporation election and Y’s QSub election were ineffective. On
   Date 4, Trust 1 sold a portion of its X stock to an individual. On Date 5, Trust 1
   distributed the rest of its X stock to A.

In addition, Trust 2 was a shareholder of X on Date 3. X represents that Trust 2 was
eligible to be an electing small business trust (ESBT) within the meaning of § 1361(e)
effective Date 3. However, no election to be an ESBT was filed on behalf of Trust 2.
Therefore, Trust 2 was not a permissible shareholder and X’s S corporation election and
Y’s QSub election, had they been valid on Date 3, were ineffective. In Year, Trust 2
transferred its shares of X stock to individual beneficiaries.

X represents that the circumstances resulting in X’s invalid S corporation election were
inadvertent and were not motivated by tax avoidance or retroactive tax planning. X
further represents that for all taxable years, it has filed returns consistent with treating X
as an S corporation and Y as a QSub. In addition, X and its shareholders agree 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-103314-15 3

Section 1361(b)(1)(B) provides that the term “small business corporation” means a
domestic corporation that is not an ineligible corporation and that does not, among other
requirements, 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 I of subchapter J of chapter 1 of the Code) 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 an ESBT, within the meaning of § 1361(e)(1),
may be a shareholder for purposes of § 1361(b)(1)(B). The trustee of the trust makes
the ESBT election pursuant to § 1361(e)(3). Section 1.1361-1(m)(2)(i) provides that the
trustee of an ESBT must make the 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(f) provides that if (1) an election under § 1362(a) or § 1361(b)(3)(B)(ii) 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 to obtain shareholder consents; (2) the Secretary determines that the
circumstances resulting in such ineffectiveness were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
ineffectiveness, steps were taken so that the corporation for which the election was
made is a small business corporation or a QSub, as the case may be, or to acquire the
required shareholder consents; and (4) the corporation for which the election was made,
and each person who was a shareholder of the corporation at any time during the
period specified pursuant to § 1362(f), agree to make the 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 this period, then, notwithstanding the
circumstances resulting in such ineffectiveness or termination, the corporation shall be
treated as an S corporation or a QSub, as the case may be, during the period specified
by the Secretary.

                                 CONCLUSION

Based solely on the facts submitted and representations made, we conclude that X’s S
corporation election and Y’s QSub election were ineffective on Date 3 as a result of the
improper consent to X’s S corporation election and because Trust 2 was an ineligible
shareholder. We further conclude that the ineffectiveness of X’s S corporation election
and Y’s QSub election constituted inadvertent invalid elections within the meaning of
§ 1362(f). Consequently, under § 1362(f), X will be treated as an S corporation from
Date 3 and thereafter provided that X’s S corporation election was otherwise valid and
PLR-103314-15 4

not otherwise terminated under § 1362(d). Furthermore, Y will be treated as a QSub of
X from Date 3 and thereafter, provided that Y’s QSub election was otherwise valid and
not otherwise terminated.

This ruling is contingent on X and its shareholders filing their federal income tax returns
consistent with X being an S corporation. This ruling is also contingent on A and B
signing a written statement as described in § 1.1362-6(b)(1) consenting to X’s S
corporation election effective Date 3. The written statement must be filed with the
appropriate service center within 120 days from the date of this letter, indicating that the
statement is to be associated with X’s originally filed Form 2553.

Except as expressly provided herein, we express or imply no opinion 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 on whether X was or is otherwise
eligible to be treated as an S corporation or whether Y was or is otherwise eligible to be
treated as a QSub.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

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

The ruling contained in this letter is 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 ruling request, it is subject to verification on examination.

                                   Sincerely,



                                   Bradford R. Poston
                                   Senior Counsel, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2):

Copy of this letter
Copy for § 6110 purposes