S corporation preserves status after invalid trust elections

Plain-English summary

An S corporation's election was ineffective because shareholder trusts lacked valid QSST or ESBT elections. The same defect invalidated elections for two qualified subchapter S subsidiaries, and three trusts did not properly complete intended conversions from QSSTs to ESBTs. The IRS treated the corporation's S election as effective until it later became another company's QSub, conditioned on the affected beneficiaries, guardians, and trustees filing corrective trust elections within 120 days. The IRS also treated the two subsidiaries as QSubs for their intended period, assuming they otherwise qualified.

Ruling snapshot

• Question: Could the corporation retain its intended S corporation and QSub treatment despite invalid trust elections?
• Outcome: Approved, subject to corrective trust elections within 120 days.
• Key authorities: IRC §§ 1361, 1362(f), 368(a)(1)(F); Treas. Reg. §§ 1.1361-1, 1.1361-3.

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201639011                                              Third Party Communication: None
Release Date: 9/23/2016                                        Date of Communication: Not Applicable
Index Number: 1362.04-00, 1361.03-02,
              1361.03-03, 1361.05-00                           Person To Contact:
                                                               --------------, ID No. -----------------
                                                               Telephone Number:
                                                               -------------------
--------------------------------------                         Refer Reply To:
--------------------------------------------------             CC:PSI:B01
------------------------------------------                     PLR-141502-15
------------------------                                       Date:
                                                               June 08, 2016




LEGEND

X                 =         -----------------------------------------------------
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Y                 =         -----------------------------------------------------------------------------------------
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                           --------------------------------------------
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A                 =         ----------------------------
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Sub 1             =         -------------------------------
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Sub 2             =         ------------------------------------------
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Trust 1           =         ------------------------------------------------
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Trust 2           =         -------------------------------------------------
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Trust 3           =         ---------------------------------------------------
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PLR-141502-15                                             2

Trust 4           =         -----------------------------------------------------
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Trust 5           =         ------------------------------------
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Trust 6           =         ----------------------------------------
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Trust 7           =         ----------------------------------------
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Trust 8           =         ----------------------------------------------------------------
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Trust 9           =         ----------------------------------------------------------------
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Trust 10          =         -----------------------------------------------
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Trust 11          =         -----------------------------------------------
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Trust 12          =         ----------------------------------------
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Trust 13          =         --------------------------------------------
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Trust 14          =         ---------------------------------------
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Trust 15          =         -----------------------------------------
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Trust 16          =         -------------------------------------
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Trust 17          =         -----------------------------------------------
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Date 1            =        --------------------------
PLR-141502-15                                       3

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

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

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

Date 5          =      --------------------------

Date 6          =      --------------------------

Date 7          =      ----------------------

Year            =      -------

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

State           =      --------



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

This responds to a letter dated December 16, 2015, and subsequent correspondence,
submitted on behalf of X, by X’s authorized representative, requesting relief under
section 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted and representations within, X was incorporated
on Date 1, under the laws of State and elected to be treated as an S corporation
effective Date 2.

As of Date 2, Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, Trust 9,
Trust 10, and Trust 11 were shareholders of X. X represents that Trust 1, Trust 2, Trust
3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8, Trust 9, Trust 10, and Trust 11 were eligible
to make Qualified Subchapter S Trust (QSST) elections as of Date 2. However, the
income beneficiaries of Trust 3, Trust 4, Trust 7, Trust 8, and Trust 10 inadvertently
failed to timely file QSST elections, thereby causing Trust 3, Trust 4, Trust 7, Trust 8,
and Trust 10 to become ineligible shareholders of X. In addition, the guardians of the
minor beneficiaries of Trust 1, Trust 2, Trust 6, Trust 9, and Trust 11 failed to timely file
QSST elections, thereby causing Trust 1, Trust 2, Trust 6, Trust 9, and Trust 11 to
become ineligible shareholders of X. As a result, X’s S election on Date 2 was invalid.
A, the beneficiary of Trust 5, timely filed a QSST election for Trust 5; however, X’s S
election was not valid on Date 2, thus invalidating Trust 5’s QSST election.
PLR-141502-15                                4


X represents that Trust 12, Trust 13, Trust 14, Trust 15, Trust 16, and Trust 17 were
eligible to make Electing Small Business Trust (ESBT) elections as of Date 2. X
represents that the trustee of Trust 12, Trust 13, Trust 14, Trust 15, Trust 16, and Trust
17 timely filed ESBT elections. However, X’s S election was not valid on Date 2, thus
invalidating Trust 12, Trust 13, Trust 14, Trust 15, Trust 16, and Trust 17’s ESBT
elections.

X represents that the trustee of Trust 4, Trust 7, and Trust 8 decided to convert Trust 4,
Trust 7, and Trust 8 from QSSTs to ESBTs effective Date 5. X represents that Trust 4,
Trust 7, and Trust 8 were eligible to make ESBT elections effective Date 5. X
represents that the trustee of Trust 4, Trust 7, and Trust 8 timely filed ESBT elections.
However, X’s S election was not valid on Date 2, thus invalidating Trust 4, Trust 7, and
Trust 8’s ESBT elections. In addition, the conversions of Trust 4, Trust 7, and Trust 8
from QSSTs to ESBTs were not valid because the trustees and beneficiaries of Trust 4,
Trust 7, and Trust 8 did not file the trust conversions pursuant to Rev. Proc. 98-23.

Effective Date 3, X elected to treat Sub 1 and Sub 2 as Qualified Subchapter S
Subsidiaries (QSubs). However, X’s S election was not valid on Date 2, thus
invalidating X’s QSub elections. X represents that on Date 4, Sub 1 and Sub 2 merged
into X.

X represents that on Date 6, the shareholders of X exchanged their X shares for non-
voting Class B shares in Y. Following this exchange, X became a wholly-owned
subsidiary of Y. Y filed a QSub election for X effective Date 7.

X represents that it owned all of the outstanding stock of Sub 1 and Sub 2 from Date 3
until Date 4 when Sub 1 and Sub 2 merged into X. X represents that it intended to elect
to treat Sub 1 and Sub 2 as QSubs effective Date 3. X also represents that X has filed
tax returns for all tax years consistent with the treatment of Sub 1 and Sub 2 as QSubs.

X represents that Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, Trust 6, Trust 7, Trust 8,
Trust 9, Trust 10, and Trust 11 have qualified as QSSTs under § 1361(d) at all times
since the date that each trust first acquired stock in X. X represents that the trusts have
filed consistently as if valid QSST elections were in place for Years. X further
represents that the failure to file QSST elections for the trusts was discovered in Year.
X represents that the minor beneficiaries of Trust 1, Trust 2, Trust 6, Trust 9 and Trust
11 have all reached the age of majority as of the date of this ruling request.

X represents that Trust 12, Trust 13, Trust 14, Trust 15, Trust 16, and Trust 17 have at
all times met the requirements of an ESBT under § 1361(d)(3) since the date that each
trust first acquired stock in X. X represents that the trusts have filed consistently as if
valid ESBT elections were in place for Years. X further represents that the failure to file
ESBT elections for the trusts was discovered in Year.
PLR-141502-15                                 5


X represents that Trust 4, Trust 7, and Trust 8 have qualified as QSSTs under § 1361(d)
at all times since the date that each trust first acquired stock in X until the date of that
each trust converted to an ESBT. X represents that Trust 4, Trust 7, and Trust 8 have
filed consistently as if valid QSST elections were in place for the years the trusts were
QSSTs and that Trust 4, Trust 7, and Trust 8 have filed consistently as if a valid ESBT
election was in place for the years the trusts were ESBTs. X further represents that the
failure to file QSST and ESBT elections for the trusts was discovered in Year.

X represents that the circumstances resulting in the failure to make the QSST and
ESBT elections were inadvertent and not motivated by tax avoidance or retroactive tax
planning. X further represents that X has filed its income tax returns consistent with
having a valid S election in effect for all taxable years since X elected to be an S
corporation and until X became a QSub of Y on Date 7. X represents that other than
the failure to make valid QSST elections on Date 2, and valid ESBT elections on Date 2
and Date 5, X has qualified as a small business corporation at all times since its election
on Date 2. Lastly, X and its shareholders agree to make any adjustments required as a
condition of obtaining relief under § 1362(f) that may be required by the Secretary.

X represents that the inadvertent invalid election of its S corporation election was
inadvertent and was not motivated by tax avoidance or retroactive tax planning.

LAW AND ANALYSIS

Section 1361(a) provides that an S corporation is a small business corporation for which
an election under § 1362(a) is in effect.

Section 1361(b)(1) provides that the terms “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 1 class of stock.

Section 1361(b)(3)(A) generally provides that a QSub shall not be treated as a
separate corporation and all assets, liabilities, and items of income, deduction, and
credit of a QSub shall be treated as assets, liabilities, and such items (as the case may
be) of the S corporation.

Section 1361(b)(3)(B) defines a QSub as a domestic corporation which is not an
ineligible corporation, if 100 percent of the stock of the corporation is owned by the S
corporation, and the S corporation elects to treat the corporation as a Qualified
subchapter S subsidiary .
PLR-141502-15                                 6

Section 1361(c)(2)(A)(i) provides that, for purposes of section 1361(b)(1)(B), a trust all
of which is treated (under subpart E of part I of subchapter J of chapter 1) as owned by
an individual who is a citizen or resident of the United States may be an S corporation
shareholder.

Section 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT is a
permissible S corporation shareholder.

Section 1361(d)(1) provides that, in the case of a QSST with respect to which a
beneficiary makes an election under paragraph 1361(d)(2), such trust shall be treated
as a trust described in subsection 1361(c)(2)(A)(i) and for purposes of section 678(a),
the beneficiary of such trust shall be treated as the owner of that portion of the trust
which consists of stock in an S corporation with respect to which the election under
paragraph 1362(d)(2) is made.

Section 1361(d)(3) defines a QSST as a trust all of the income (within the meaning of
section 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. In addition, the terms of the
trust must require that (i) during the lifetime 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 such 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 such beneficiary.

Section 1361(e)(3) provides that an election under § 1361(e) shall be made by the
trustee. Any such election shall apply to the taxable year of the trust for which made and
all subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

Section 1.1361-1(m)(2)(i), of the Income Tax Regulations, 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 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the ESBT
election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a QSST
election (generally within the 16-day-and-2-month period beginning on the day that the
stock is transferred to the trust).

Section 1.1361-3(a) prescribes the time and manner for making an election to be
classified as a QSub.
PLR-141502-15                                7

Section 1.1361-3(a)(4) provides that an election may be effective up to two months and
15 days prior to the date the election is filed or not more than 12 months after the
election is filed. The proper form for making the election is Form 8869, Qualified
subchapter S subsidiary Election.

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(a)(2) provides that an election under § 1362(a) shall be valid
only if all persons who are shareholders in such corporation on the day on which such
election is made consent to such election.

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 relevant part, 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 § (b)(2)) by reason of a failure to meet the
requirements of § 1361(b) or to obtain shareholder consents, or (B) was terminated
under paragraph (2) or (3) § 1362(d) or § 1361(b)(3)(C); (2) the Secretary determines
that the circumstances resulting in such ineffectiveness or termination were inadvertent;
(3) no later than a reasonable period of time after discovery of the circumstances
resulting in such 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 QSub, as the case may be, or (B) to acquire the required
shareholder consents; and (4) the corporation for which the election was made or the
termination occurred, and each person who was a shareholder in such corporation at
any time during the period specified pursuant to § 1362(f), agrees to make such
adjustments (consistent with the treatment of such 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 such ineffectiveness or
termination, such corporation shall be treated as an S corporation or a Qsub, as the
case may be, during the period specified by the Secretary.

Rev. Rul. 2008-18, situation 2, holds that, consistent with Rev. Rul. 64-250, a
reorganization under § 368(a)(1)(F) did not cause the termination of an S corporation
election under § 1362. In Rev. Proc. 2008-18, C, an individual, owned all of the stock of
Z, an S corporation. In Year 1, Z formed Newco, which in turn forms Mergeco. Pursuant
to a plan of reorganization, Mergeco merges with and into Z, with Z surviving and C
receiving solely Newco stock in exchange for Z stock. Newco meets the requirements
for qualification as a small business corporation and timely elects to treat Z as a QSub,
effective immediately following the transaction. The transaction met the requirements of
a reorganization under § 368(a)(1)(F) and Z’s original S corporation election continued
PLR-141502-15                                8

for Newco. Newco must obtain a new EIN. Z must retain its EIN even though a QSub
election is made for Z and must use its original EIN any time the QSub is otherwise
treated as a separate entity for federal tax purposes (including for employment and
certain excise taxes) or if the QSub election terminates.

Rev. Rul. 64-250, 1964-2, C.B. 333, holds that a reorganization under § 368(a)(1)(F) did
not cause a termination of an election under form § 1372, the predecessor to § 1362. In
that revenue ruling, an electing small business corporation within the meaning of former
§ 1371(b) was reincorporated in another state through the corporation's shareholders
organizing a new corporation in the other state and merging the existing corporation into
the new corporation. The revenue ruling states that the surviving corporation also met
the requirements for qualification as a small business corporation.

Rev. Proc. 98-23, section 4.01, provides, in relevant part, that a trust may convert from
a QSST to an ESBT if the trust (1) meets all the requirements to be an ESBT, except for
the requirement that the trust not have a QSST election in place under § 1361(d)(2); (2)
the trustee and the current income beneficiary of the trust make the ESBT election
pursuant to section 4.02 of this Rev. Proc. with respect to the stock of each S
corporation held by the trust; (3), the trust has not converted from an ESBT to a QSST
within the 36 month period preceding the effective date of the new ESBT election; (4)
except as provided in section 6 of this Rev. Proc., the effective date of the ESBT
election cannot be more than 15 days and 2 months prior to the date on which the
election is filed and cannot be more than 12 months after the date on which the election
is filed. If an election specifies an effective date more than 15 days and 2 months prior
to the date on which the election is filed, it will be effective 15 days and 2 months prior
to the date on which it is filed. If an election specifies an effective date more than 12
months after the date on which the election is filed, it will be effective 12 months after
the date it was filed.

Rev. Proc. 98-23, section 4.02, provides, in relevant part, that the current income
beneficiary and the trustee of the trust must sign the ESBT election and file it with the
service center where the S corporation files its income tax return. This ESBT election
must state at the top of the document “ATTENTION ENTITY CONTROL –
CONVERSION OF A QSST TO AN ESBT PURSUANT TO REV. PROC. 98-23”
(emphasis in original) and include all the information otherwise required for an ESBT
election. A separate election must be made with respect to the stock of each S
corporation held by the trust.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S election was ineffective on Date 2. We further conclude that the missed QSST
elections that caused the ineffectiveness were inadvertent within the meaning of
§ 1362(f). Therefore, X will be treated as an S corporation effective Date 2 and
PLR-141502-15                                 9

thereafter until Date 7, provided X’s S corporation election is otherwise valid and not
otherwise terminated under § 1362(d).

This letter ruling is subject to the following conditions. No later than 120 days from the
date of this letter: (1) the beneficiaries of Trust 3, Trust 4, Trust 5, Trust 7, Trust 8 and
Trust 10 must file a QSST for Trust 3, Trust 4, Trust 5, Trust 7, Trust 8 and Trust 10
effective Date 2; (2) both the former guardians and the beneficiaries of Trust 1, Trust 2,
Trust 6, Trust 9 and Trust 11 must sign and file the QSST election for Trust 1, Trust 2,
Trust 6, Trust 9 and Trust 11 effective Date 2; (3) the trustee of Trust 12, Trust 13, Trust
14, Trust 15, Trust 16 and Trust 17 must file an ESBT election for Trust 12, Trust 13,
Trust 14, Trust 15, Trust 16 and Trust 17 effective Date 2; (4) the trustee and
beneficiaries of Trust 4, Trust 7, and Trust 8 must file the trust conversions to convert
Trust 4, Trust 7, and Trust 8 from QSSTs to ESBTs effective Date 5 pursuant to Rev.
Proc. 98-23.

These elections must be made with the appropriate service center within 120 days from
the date of this letter. A copy of this letter should be attached to the elections. If these
conditions are not met, then this ruling is null and void. Furthermore, if these conditions
are not met, X must send notification that its S election has terminated to the service
center with which X’s S election was filed.

Furthermore, Sub 1 and Sub 2 will be treated as QSubs effective Date 3 through Date
4, provided Sub 1 and Sub 2 otherwise are eligible to be treated as QSubs.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, no opinion is expressed or implied concerning whether X
otherwise qualifies as an S corporation, or whether Sub 1 and Sub 2 are eligible to be
QSubs, for federal tax purposes.

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-141502-15                                  10

In accordance with the power of attorney on file with this office, a copy of this letter is
being sent to the taxpayer’s authorized representatives.



                                        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