S corporation election is restored after an inadvertent termination from excess passive income

Plain-English summary

A company that had elected to be taxed as an S corporation lost that status by operation of law. Under § 1362(d)(3), an S corporation's election terminates automatically if it has leftover C corporation earnings and profits at the close of three straight years and, in each of those years, more than 25 percent of its gross receipts is passive investment income (rents, royalties, dividends, interest, and annuities). That happened here, so the election ended. The company asked the IRS to treat the termination as inadvertent under § 1362(f), representing that it was not motivated by tax avoidance and that it and its shareholders would make any corrective adjustments. The IRS agreed the termination was inadvertent and ruled that the company will be treated as having continued as an S corporation, on the condition that it pay a specified amount (the passive-income tax under § 1375) within 120 days and meet the other stated terms; if the conditions are not met, the ruling is void. This matters to closely held businesses because a purely mechanical S-election termination can usually be undone through § 1362(f) relief without permanently losing passthrough treatment.

Ruling snapshot

• Question: Was the termination of the company's S corporation election (caused by three years of excess passive investment income with C corporation earnings and profits) inadvertent, allowing continued S corporation treatment?
• Outcome: Approved (inadvertent termination relief granted under § 1362(f), conditioned on a payment within 120 days).
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1361(a)(1), 1375(a).

Full text (IRS public release)

Internal Revenue Service                       Department of the Treasury
                                               Washington, DC 20224

Number: 201831005                    Third Party Communication: None
Release Date: 8/3/2018               Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00,
              1362.02-03, 1362.02-00  Person To Contact:
                                     -------------------------, ID No. -----------------
----------------------               -----------------------------------------------------
-----------------------------------  Telephone Number:
-------------------------------      ----------------------
--------------------------------     Refer Reply To:
                                     CC:PSI:B3
                                     PLR-132245-17
                                     Date:
                                     April 17, 2018

LEGEND

Company = ---------------------
          ------------------------

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

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

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

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

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

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

Year 1         = -------

a              = --------------

b              = ------------------

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

      This letter responds to a letter dated October 20, 2017, and subsequent
correspondence, submitted on behalf of Company by Company's representative,
requesting a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                         FACTS

        According to the information submitted, Company is a State corporation that has
had an S corporation election in effect as of Date 1. At the close of three consecutive
taxable years ending Date 4, Company had subchapter C accumulated earnings and
profits of a. Moreover, for each taxable year ending Date 2, Date 3, and Date 4,
Company had passive investment income (within the meaning of § 1362(d)(3)) in
excess of 25 percent of its gross receipts. As a result, Company's S corporation
election terminated on Date 5.

       Company represents that the circumstances resulting in the termination of
Company's S corporation election were inadvertent and were not motivated by tax
avoidance or retroactive tax planning. Company and its shareholders have consistently
treated Company as an S corporation and agree to make any adjustments consistent
with the treatment of Company 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 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be
terminated whenever the corporation has accumulated earnings and profits at the close
of each of three consecutive taxable years, and has gross receipts for each of the
taxable years more than 25 percent of which are passive investment income.

        Section 1362(d)(3)(A)(ii) provides that the termination under § 1362(d)(3) shall be
effective on and after the first day of the first taxable year beginning after the third
consecutive taxable year referred to in § 1362(d)(3)(A)(i).

       Section 1362(d)(3)(C)(i) defines the term "passive investment income" to mean,
except as otherwise provided in § 1362(d)(3), gross receipts derived from royalties,
rents, dividends, interest, and annuities.

        Section 1362(f) provides, in part, 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 1375(a) provides that if an S corporation has accumulated earnings and
profits at the close of a taxable year and gross receipts for that taxable year more than
25 percent of which are passive investment income, then there is imposed a tax on the
income of such corporation for such taxable year. Such tax shall be computed by
multiplying the excess net passive income by the highest rate of tax specified in § 11(b).

                                      CONCLUSION

       Based solely on the representations made and the information submitted, we
conclude that Company's S corporation election terminated on Date 5, under
§ 1362(d)(3)(A) because Company had subchapter C earnings and profits at the close
of each of three consecutive taxable years beginning in Year 1, and had gross receipts
for each of those taxable years more than 25 percent of which were passive investment
income. We further conclude that the termination of Company's S corporation election
was an inadvertent termination within the meaning of § 1362(f).

        Pursuant to the provisions of § 1362(f), Company will be treated as continuing to
be an S corporation beginning on Date 5, and thereafter, provided that Company's S
corporation election was valid and has not otherwise terminated under § 1362(d) and
the following conditions are met. This letter ruling is subject to the following condition:
an adjustment under § 1362(f)(4), Company must send a payment of b with a copy of
this letter to the following address:

Internal Revenue Service
Cincinnati Service Center
201 West Rivercenter Blvd.
Covington, KY 41011
Stop 31
Terri Lackey
Manual Deposit

        Company must send this payment no later than 120 days from the date of this
letter. If all the above conditions are not met, then this ruling is null and void.
Furthermore, if these conditions are not met, Company must notify the Cincinnati
Service Center that its S corporation election has terminated.

         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 Company's
eligibility to be an S corporation.

      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.

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

       The ruling contained in this letter is 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 ruling request, it is subject to verification on examination.

                                      Sincerely,



                                      Bradford R Poston
                                      Special Counsel to the Associate Chief Counsel
                                      Office of Associate Chief Counsel
                                      (Passthroughs & Special Industries)

Enclosures: Copy of this letter
            Copy for § 6110 purposes

cc: