Missed ESBT elections do not invalidate corporation's S status

Plain-English summary

Two trusts held shares when a corporation's S election became effective, but their trustee did not timely file electing small business trust elections. The corporation and trusts consistently filed as though valid S and ESBT elections were in place, and the failure was discovered and addressed without tax-avoidance motives. The IRS treated the resulting invalid S election as inadvertent under section 1362(f). The corporation would continue to be treated as an S corporation from the original effective date if the two trusts filed their ESBT elections within 120 days.

Ruling snapshot

• Question: Could the corporation retain S status despite two shareholder trusts' failure to timely elect ESBT treatment?
• Outcome: approved
• Key authorities: IRC §§ 1361(c)(2), 1361(e), and 1362(f); Treas. Reg. § 1.1361-1(m)(2)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201730021 Third Party Communication: None
Release Date: 7/28/2017 Date of Communication: Not Applicable
Index Number: 1361.03-03, 1362.02-02
Person To Contact:
----------------------------- ----------------, ID No. ------------------
--------------------------------------- Telephone Number:
------------------------------- ------------------
--------------------------------- Refer Reply To:
CC:PSI:B01
PLR-137406-16
Date:
April 04, 2017

LEGEND

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

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

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

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

State = ---------

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

This responds to a letter dated September 7, 2016, and supplemental correspondence,
submitted on behalf of X, by X’s authorized representative, requesting relief under
section 1362(f) of the Internal Revenue Code (the Code).

FACTS

According to the information submitted and representations within, X was formed and
made a timely S corporation election effective Date 1, under the laws of State.
PLR-137406-16 2

X represents that on Date 1, Trust 1 and Trust 2 were shareholders of X. Trust 1 and
Trust 2 failed to make a timely Electing Small Business Trust (ESBT) elections, thus
causing X’s S corporation election to be invalid.

X represents that Trust 1 and Trust 2 were eligible to make an Electing Small Business
Trust (ESBT) elections as of Date 1, however, the trustee of Trust 1 and Trust 2
inadvertently failed to file an ESBT elections. X represents that Trust 1 and Trust 2
have been treated as if a valid ESBT elections had been made on Date 1 and have at
all times since Date 1 met the requirements of an ESBT under § 1361(d)(3). X further
represents that Trust 1 and Trust 2 reported their allocable shares of Trust 1 and Trust 2
income on all affected returns consistent with being an ESBT.

X represents that upon discovering that its S election was invalid, X took corrective
action by filing this request for relief. X represents that the circumstances resulting in
the inadvertent invalid election and the failure to make timely 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. X
represents that other than the failure to make a valid ESBT election on Date 1, X has
qualified as a small business corporation at all times since its election on Date 1.
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.

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(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) 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(e) an ESBT means any trust if (i) such trust does not have as a
beneficiary any person other than (I) an individual, (II) an estate, (III) an organization
described in § 170(c)(1) which holds a contingent interest in such trust and is not a
potential current beneficiary, (ii) no interest in such trust was acquired by purchase, and
(iii) an election under § 1361(e) applies to such trust.
PLR-137406-16 3

Section 1361(c)(2)(A)(i) of the Code provides that for purposes of section 1361(b)(1) a
trust all of which is treated (under subpart E of part I of subchapter J of this chapter) 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 shareholder.

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) 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 1362(a) provides that a small business corporation may elect to be an S
corporation.

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) 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); (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 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 during the period
specified pursuant to § 1362(f), agrees to make the adjustments (consistent with the
treatment of such corporation as an S corporation) 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
PLR-137406-16 4

during the period specified by the Secretary.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
the failure of Trust 1 and Trust 2 to make ESBT elections effective Date 1 caused an
inadvertent invalid election of X’s S corporation election within the meaning of § 1362(f)
on Date 1. Pursuant to the provisions of § 1362(f), X will be treated as continuing to be
an S corporation beginning on and after Date 1, unless X's S corporation election is
otherwise terminated under § 1362(d).

This letter ruling is subject to the condition that within 120 days from the date of this
letter, an election to treat Trust1 and Trust 2 as ESBTs effective Date 1, must be made
with the appropriate service center. A copy of this letter should be attached to the
ESBT election. If this condition is not met, then this ruling is null and void.
Furthermore, if this condition is not met, X must send notification that its S election has
terminated to the service center with which X’s S election was filed.

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 or whether Trust 1 and Trust 2 were or are otherwise eligible to be ESBTs.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

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

                                   Sincerely,


                                   Laura C. Fields
                                   Laura C. Fields
                                   General Attorney, 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