S corporation receives relief for an inadvertent termination

Plain-English summary

An S corporation transferred all its shares to an entity owned by a married couple as community property. Because that entity was treated as a partnership, it was an ineligible S corporation shareholder and caused the S election to terminate. The IRS found that the termination was inadvertent and permitted the corporation to continue as an S corporation. Relief was conditioned on the owners treating the shareholder entity as disregarded for all open tax years and on the S election not otherwise terminating.

Ruling snapshot

• Question: Could the corporation retain S corporation status after an ineligible shareholder caused its election to terminate?
• Outcome: Approved as an inadvertent termination, subject to corrective tax treatment.
• Key authorities: IRC §§ 1361 and 1362(f); Rev. Proc. 2002-69; Treas. Reg. § 301.7701-2

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201610007                                             Third Party Communication: None
Release Date: 3/4/2016                                        Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                              Person To Contact:
------------------------------------------                    --------------, ID No. ----------------
-------------------------------                               Telephone Number:
---------------------------                                   --------------------
----------------------------------------                      Refer Reply To:
                                                              CC:PSI:BO1
                                                              PLR-123066-15
                                                              Date:
                                                              December 02, 2015


LEGEND

X                 =         -------------------------------
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Y                 =         ------------------------------
---------------------------------------------------

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

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

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

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

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

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


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

This responds to a letter dated June 30, 2015, submitted on behalf of X, by X’s
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code (the Code).
PLR-123066-15                                2


FACTS

According to the information submitted and representations made within, X was
incorporated on Date 1, under the laws of State, a community property state, and made
a valid S election effective Date 2.

On Date 3 all of the shares of X were transferred to Y. Y was formed on Date 3 under
the laws of State and is wholly owned by A and B, a husband and wife as community
property. Y was treated as a partnership for income tax purposes.

On Date 4, X discovered that Y is an ineligible shareholder that caused X’s S election to
termination effective Date 3.

X represents that if its S corporation election terminated it was inadvertent and was not
motivated by tax avoidance or retroactive tax planning. X also 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. X further represents that X and its shareholders have
filed consistently with X continuing to be a valid S corporation.

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 the 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 subsection (c)(2), or an organization described in subsection (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 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 part that if (1) an election under § 1362(a) by any
corporation was terminated under § 1362(d), (2) the Secretary determines that the
circumstances resulting in the termination were inadvertent, (3) no later than a
reasonable period of time after the discovery of the circumstances resulting in the
termination, steps were taken so that the corporation for which the termination occurred
is a small business corporation, and (4) the corporation for which the termination
occurred, and each person who was a shareholder in such corporation at any time
PLR-123066-15                                 3

during the period of inadvertent termination of the S election, agrees to makes such
adjustments (consistent with the treatment of the corporation as an S corporation) as
may be required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in the termination, the corporation shall be treated as an S
corporation during the period specified by the Secretary.

Rev. Proc. 2002-69, 2002-2 C.B. 831, provides guidance on the classification of a
business entity owned by a husband and wife as community property. If the husband
and wife treat a qualified entity as a disregarded entity for federal income tax purposes,
the Service will respect that treatment. If the husband and wife treat a qualified entity as
a partnership for federal income tax purposes and file the appropriate partnership
returns, the Service will respect that treatment. A change in reporting position will be
treated as a conversion of the entity. A business entity is a qualified entity if (1) it is
wholly owned by a husband and wife as community property under the laws of a state, a
foreign country, or a possession of the United States; (2) no person other than one or
both spouses would be considered an owner for federal tax purposes; and (3) the
business entity is not treated as a corporation under § 301.7701-2.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 3 because X had an ineligible
shareholder. However, we conclude that the termination was inadvertent within the
meaning of § 1362(f). Therefore, X will be treated as an S corporation effective Date 3
and thereafter, provided that Y, and A and B, treat Y as a disregarded entity for federal
income taxes for all open taxable years and X’s S corporation election is not otherwise
terminated under § 1362(d).

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 requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.
PLR-123066-15                                4

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

                                      Sincerely,


                                      David R. Haglund
                                      David R. Haglund
                                      Branch Chief, Branch 1
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)




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


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