Corporate group receives relief after trusts miss ESBT elections

Plain-English summary

Two trusts held shares of an S corporation but their trustees failed to make timely electing small business trust elections. The failure affected that corporation and a successor S corporation created through a statutory merger. A third trust's ESBT election was also ineffective because the successor's S status had already terminated, which in turn affected a later parent and QSub restructuring. The corporations and trusts filed consistently with the intended S and ESBT treatment and represented that the failures were inadvertent. The IRS granted continuous S corporation treatment, conditioned on all three trusts filing the required ESBT elections within 120 days and the shareholders making the required income, basis, and distribution adjustments.

Ruling snapshot

• Question: Could three related corporations receive inadvertent-termination relief after shareholder trusts failed or made ineffective ESBT elections?
• Outcome: Approved; continuous S status was granted subject to timely corrective trust elections and shareholder adjustments.
• Key authorities: IRC §§ 1361(e), 1362(f), and 1366 through 1368; Rev. Ruls. 64-250 and 2008-18

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201821001 Third Party Communication: None
Release Date: 5/25/2018 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
------------------------------------------- -----------------------------, ID No. -------------
------------------------------------------- -----------------
-------------------------- Telephone Number:
-------------------------------------------- ----------------------
Refer Reply To:
CC:PSI:01
PLR-125368-17
Date:
February 21, 2018

Legend

X = ----------------------------------------------------------------------------------------------------
------------------------
Y = ----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
------------------------
Z = ----------------------------------------------------------------------------------------------------
-----------------------
State = --------------
Trust 1 = ----------------------------------------------------------------------------------------------------
-------------------------
Trust 2 = ----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
-----------------------
Trust 3 = ----------------------------------------------------------------------------------------------------
-----------------------
A = ----------------------------------------------------------------------------------------------------
------------------------
Date 1 = --------------------------
Date 2 = -----------------
Date 3 = -----------------
Date 4 = -----------------
Date 5 = -------------------
Date 6 = -------------------
Date 7 = --------------------------
Date 8 = ---------------------------

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

  This responds to a letter dated August 11, 2017, and subsequent

correspondence submitted on behalf of Z by Z’s authorized representative, requesting
inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

                                     FACTS

    The information submitted states that X was incorporated under the laws of State

on Date 1. X filed a timely election under § 1362(a) to be treated as an S corporation
effective Date 2. On Date 2, Trust 1 and Trust 2 each owned shares of X stock.

    Z represents that Trust 1 and Trust 2 each qualified to elect to be treated as

electing small business trusts (ESBTs) under § 1361(e), however, the trustees for each
of the trusts failed to make timely ESBT elections within the meaning of
§1361(e)(1)(A)(v) thereby causing X’s S corporation election to be ineffective due to X’s
failure to meet all the requirement of § 1361(a).

   Y was incorporated on Date 3 and was wholly-owned by A. Y filed a timely

election under § 1362(a) to be treated as an S corporation effective Date 4. On Date 5,
X merged into Y in a § 368(a)(1)(A) statutory merger. As a result of the merger, the
shares of X stock owned by Trust 1 and Trust 2 were converted by operation of law into
share of Y. Z represents that Trust 1 and Trust 2 each qualified to elect to be treated
as ESBTs under § 1361(e), however, the trustees for each of the trusts failed to make
timely ESBT elections within the meaning of §1361(e)(1)(A)(v) thereby causing Y’s S
corporation election to terminate.

   On Date 6, Trust 1 transferred its shares of Y stock to Trust 3. The trustee of

Trust 3 timely filed an election pursuant to § 1361(e) to be treated as an ESBT effective
Date 6. However, Y’ s S corporation election was not valid on Date 6, thus invalidating
Trust 3’s ESBT election.

    According to the information submitted Z was organized under the laws of State

on Date 7, and filed a timely election under § 1362(a) to be treated as an S corporation
effective Date 8. On Date 8, incident to what Z represents was part of a reorganization
under § 368(a)(1)(F), Y’s shareholders contributed all of their stock in Y to Z, thereby
causing Y to become a wholly-owned subsidiary of Z. Afterwards, Z made an election
to treat Y as a qualified subchapter S subsidiary (QSub) effective Date 8. On Date 7, Y
was owned by A and Trust 3.

  Z represents that the circumstances resulting in the termination of X, Y, and Z’s S

corporation elections were inadvertent and not motivated by tax avoidance. Z further
represents that X, Y, and Z filed returns consistent with their respective status as an S
corporation. Z also represents that at all times Trust 1 and Trust 2 each qualified to be

an ESBT and continue to qualify as an ESBT. X further represents that Trust 1, Trust 2,
and Trust 3 each filed returns consistent with rules applicable to ESBTs. Z and its
shareholders agree to make such adjustments (consistent with the treatment of X. Y,
and Z 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.

   Section 1361(b)(1)(B) provides that, for purposes of subchapter S, the term

“small business corporation” means a domestic corporation which is not an ineligible
corporation and which does not 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)(v) provides that for the purposes of § 1362(b)(1)(B), an

ESBT may be a shareholder.

     Section 1361(e)(1)(A) provides that for purposes of § 1361, except as provided in

§ 1361(e)(1)(B), the term “electing small business trust” 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)(2), (3), (4), or (5), or (IV) 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. Section 1361(e)(3) provides that
an election under § 1361(e) shall 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, in part, that

the trustee of the trust 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 1362(d)(2) 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 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 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) as may be
required by the Secretary with respect to such period, then, notwithstanding the
circumstances resulting in such termination, such corporation shall be treated as an S
corporation during the period specified by the Secretary.

   Section 1.1362-4(b) provides, in relevant part, that for purposes of § 1.1362-4(a),

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 terminating 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 was inadvertent.

   Section 1.1362-4(d) provides, in part, that the Commissioner may require any

adjustments that are appropriate. In general, the adjustments should be consistent with
the treatment of the corporation as an S corporation during the period specified by the
Commissioner.

   Rev. Rul. 2008-18, 2008-1 C.B. 674, 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 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.

                                 CONCLUSION

    Based solely on the facts submitted and representations made, we conclude that

X's S corporation election terminated beginning on Date 2 because the trustees of Trust
1 and Trust 2 failed to timely file the required ESBT elections under § 1361(e)(1)(A)(v).
The failure to timely file the required ESBT elections under § 1361(e)(1)(A)(v) on behalf
of Trust 1 and Trust 2 also resulted in the termination of Y beginning on Date 5. We
also conclude that because Y’s S corporation election had terminated, the ESBT
election made by Trust 3 was ineffective thus the S corporation election by Z was
terminated on Date 8. We further conclude that these terminations were inadvertent
within the meaning of § 1362(f) and (1) X will continue to be treated as an S corporation
for the period from Date 2, (2) Y will continue to be treated as an S corporation for the
period from Date 5, and (3) Z will continue to be treated as an S corporation for the
period from Date 7, provided that X, Y, and Z’s S corporation elections were valid and
were not otherwise terminated under § 1362(d).

   This ruling is conditioned upon the trustees of Trust 1 and Trust 2 filing ESBT

elections effective upon Date 2 and Trust 3 file a new ESBT election effective as of Date

6. The elections must be filed with the appropriate service center within 120 days of the
   date of this ruling. A copy of this letter should be attached to the ESBT elections.

   Accordingly, X, Y and Z’s shareholders, in determining their respective income
   

   tax liabilities, must include their pro rata share of the separately stated and
   nonseparately computed items of X, Y, or Z, respectively, as provided in § 1366, make
   any adjustments to stock basis as provided in § 1367, and take into account
   distributions made by X, Y, or Z as provided by § 1368.

   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 regarding whether X, Y or Z
   are otherwise eligible to be treated as an S corporation or whether Trust , Trust 2, or
   Trust 3 is eligible to be treated as an ESBT. 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. Pursuant to a power of attorney on file, a copy of this letter is being sent
to Z’s authorized representative.

                                         Sincerely,

                                            Laura C. Fields
                                         Laura C. Fields
                                         Senior Technician Reviewer, Branch 1
                                         (Passthroughs & Special Industries)

Enclosures (2)
Copy of Letter
Copy for 6110 purposes

cc: