Ineligible shareholder caused an inadvertent S termination

Plain-English summary

Shares of an S corporation were sold to an entity that was not an eligible S corporation shareholder, even though that entity's members were eligible individuals. The entity and its members later entered a nominee agreement treating those individuals as the beneficial owners from the purchase date. The corporation represented that the transfer involved no tax avoidance or retroactive tax planning and that all parties had reported consistently with S status. The IRS ruled that the termination was inadvertent and allowed the corporation to remain an S corporation from the transfer date forward, provided its election was otherwise valid and not otherwise terminated.

Ruling snapshot

• Question: Was the S corporation termination caused by the ineligible shareholder inadvertent?
• Outcome: Approved, with continued S treatment subject to the election otherwise remaining valid
• Key authorities: IRC §§ 1361 and 1362(f); Treas. Reg. § 1.1362-4

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201633005
Third Party Communication: None
Release Date: 8/12/2016
Date of Communication: Not Applicable
Index Numbers:1362.00-00, 1362.04-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B3
PLR-104639-16
Date:
April 14, 2016

Legend

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

A = ------------------------
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B = ----------------------
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C = -------------------
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State = --------------

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

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

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

Date 4 = -------------------
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Dear -----------------:

This letter responds to a letter dated February 8, 2016, and subsequent correspondence, submitted on behalf of X by its authorized representatives, requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

Facts

The information submitted states that X was incorporated under the laws of State on Date 1. X elected to be an S corporation effective Date 2. On Date 3, shares of X were sold to Y, an ineligible shareholder under § 1361(b)(1). The members of Y are A, B, and C, eligible shareholders under § 1361(b)(1). On Date 4, Y, A, B, and C entered into a Nominee Agreement to treat A, B, and C as the beneficial owners of the shares of X nominally held by Y, effective Date 3.

X represents that there was no tax avoidance or retroactive tax planning involved in the transfer of shares of X to Y. 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. X also represents that X and all its shareholders have filed consistently with X being treated as an S corporation. In addition, X represents that all items allocable to the shares originally purchased by Y were allocated to and reported by A, B, and C, eligible shareholders.

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.

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 1362(a)(1) 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 1362(d)(2)(A) provides that an election under § 1362(a) is 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
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corporation. Section 1362(d)(2)(B) provides that any termination under § 1362(d)(2)(A) is effective on and after the date of cessation.

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 such 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 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) as may be required by the Secretary with respect to this 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.

Section 1.1362-4(b) provides that the determination of whether a termination was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination was inadvertent. The fact that the termination event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination of the election was inadvertent.

Conclusion

Based solely on the facts submitted and representations made, we conclude that X’s S corporation election was terminated on Date 3 and that the termination was inadvertent within the meaning of § 1362(f). Consequently, we rule that X will be treated as an S corporation from Date 3 and thereafter provided that X’s S corporation election was otherwise valid and not otherwise terminated under § 1362(d).

Except as specifically ruled above, we express or imply no opinion concerning the federal tax consequences of the facts described above under any other provision of the Code, including whether X was otherwise a valid S corporation and whether the Nominee Agreement between Y, A, B, and C is a valid Nominee Agreement.

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 for precedent.

Pursuant to a power of attorney on file, we are sending a copy of this letter to X’s authorized representatives.
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The rulings contained in this letter are 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 rulings requested, it is subject to verification on examination.

Sincerely,

James A. Quinn
Senior Counsel, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

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