Restores S status after three years of passive income

Plain-English summary

An S corporation had accumulated earnings and profits from its prior C corporation period and received more than 25 percent passive investment income for three consecutive years. Those facts automatically terminated its S election under Section 1362(d)(3). The corporation said its advisers had failed to explain the passive-income rule and that it and its shareholder continued filing consistently as an S corporation. The IRS found the termination inadvertent and allowed the corporation to be treated as continuously maintaining S status. Relief required the corporation to distribute all accumulated earnings and profits by a specified date and make a required payment within 120 days.

Ruling snapshot

• Question: Could the corporation obtain inadvertent-termination relief after excess passive investment income ended its S election?
• Outcome: Approved conditionally, subject to distributing all accumulated earnings and profits and making the required payment on time.
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1368(e)(3), 1375; Treas. Reg. §§ 1.1362-4, 1.1368-1(f)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201827010
Third Party Communication: None
Release Date: 7/6/2018
Date of Communication: Not Applicable
Index Number: 1362.04-00, 1362.02-03
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:B01
PLR-136569-17
Date:
April 03, 2018

LEGEND

X = -----------------
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D1 = ----------------------

D2 = ------------------

D3 = ----------------------

D4 = ---------------------------

Year1 = ---------------------------

Year2 = ---------------------------

Year3 = ---------------------------

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

$a = ------------------

$b = --------------------------------------------------------------------------

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

This responds to a letter dated December 1, 2017, and subsequent correspondence, submitted on behalf of X by X’s authorized representative, requesting inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted and representations made, X was incorporated on D1, under the laws of State. Effective D2, X elected to be taxed as an S corporation.

For X’s taxable years ending Year1, Year2, and Year3, X’s passive investment income exceeded 25% of its gross receipts. Furthermore, X had C corporation accumulated earnings and profits (AE&P) for each of the years stated above. As a result, X’s S election terminated on D3.

X represents that it has accumulated earnings & profits (AE&P) of $a. X represents that it will make a distribution of its AE&P of $a on or before D4.

X represents that its tax advisors inadvertently failed to inform X of the passive investment rules. In addition, X represents that the termination of X’s S election was inadvertent and did not involve retroactive tax planning or tax avoidance. X further represents that X and its shareholder continued to consistently treat X as an S corporation and that X and its shareholder agree to make any adjustments required as a condition of obtaining relief under the inadvertent termination rule of § 1362(f) that 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) 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 § 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 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(d)(3)(A)(i) provides that an election under § 1362(a) shall be terminated whenever the corporation (I) has accumulated earnings and profits at the close of each of 3 consecutive taxable years, and (II) has gross receipts for each of such taxable years more than 25 percent of which are passive investment income.

Section 1362(d)(3)(C)(i) provides that except as otherwise provided in § 1362(d)(3)(C), the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, and annuities.

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 during the period specified by the Secretary.

Section 1.1362-4(b) provides, in relevant part, 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 terminating event was not reasonably within the control of the corporation and, in the case of a termination, 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.

Section 1.1362-4(d) provides that the Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the Commissioner.

Section 1375 imposes a tax on the income of an S corporation that has accumulated earnings and profits at the close of a taxable year, and that has gross receipts more than 25% of which are passive investment income (within the meaning of § 1362(d)(3)).

Section 1375(b)(1)(B) provides that the amount of the excess net passive income for any taxable year shall not exceed the amount of the corporation's taxable income for such taxable year as determined under § 63(a)--(i) without regard to the deductions allowed by part VIII of subchapter B (other than the deduction allowed by § 248, relating to organizational expenditures), and (ii) without regard to the deduction under § 172.

Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or part of its accumulated earnings and profits through a deemed dividend. If an S corporation makes the election provided in § 1.1368-1(f)(3), the S corporation will be considered to have made the election under § 1368(e)(3) and § 1.1368-1(f)(2) to distribute earnings and profits first.

Section 1.1368-1(f)(5)(iii) provides that a corporation makes an election for a taxable year under § 1.1368-1(f) by attaching a statement to a timely filed (including extensions) original or amended return required to be filed under § 6037 for that taxable year. In the statement, the corporation must identify the election it is making under § 1.1368-1(f) and must state that each shareholder consents to the election. In the case of elections for taxable years beginning before January 1, 2003, an officer of the corporation must sign under penalties of perjury the statement on behalf of the corporation. In the case of elections for taxable years beginning after December 31, 2002, the statement described in this paragraph (f)(5)(iii) shall be verified by signing the return. A statement of election to make a deemed dividend under § 1.1368-1(f) must include the amount of the deemed dividend that is distributed to each shareholder.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that X's S corporation election terminated on D3, because for three consecutive years, X had AE&P and more than 25 percent of X’s income was passive activity income under
§ 1362(d)(3)(A). We further conclude that the termination of X’s S election on D3 was inadvertent within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S corporation on and after D3, provided X’s S corporation election was valid and is not otherwise terminated under § 1362(d).

This letter ruling is subject to the following conditions: (1) X actually making a distribution of all of its AE&P of $a through a distribution on or before D4; and (2) as an adjustment under § 1362(f)(4), a payment of $b and a copy of this letter must be sent to the following address: Internal Revenue Service, Cincinnati Service Center, 201 West Rivercenter Blvd., Covington, KY 41011, Stop 31, Terri Lackey, Manual Deposit. This payment must be sent no later than 120 days from the date of this letter; and 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.

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 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,

Wendy L. Kribell
Wendy L. Kribell
Assistant to the 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

cc: