S corporation's inadvertent termination is excused after six trust shareholders missed their ESBT elections

Plain-English summary

A corporation elected to be taxed as an S corporation, the pass-through regime that avoids corporate-level tax. Six trusts were shareholders. A trust can hold S corporation stock only if it fits an allowed category, and here each trust was meant to be an "electing small business trust" (ESBT), which requires the trustee to affirmatively file an ESBT election. No valid ESBT election was filed for any of the six trusts, so they were ineligible shareholders and the corporation's S election automatically terminated. The corporation asked the IRS to treat the lapse as an "inadvertent termination" under IRC § 1362(f), which lets the IRS restore S status when the break was accidental, promptly corrected, and all shareholders agree to conforming tax treatment. The IRS agreed the termination was inadvertent and ruled the corporation will be treated as continuing to be an S corporation effective the termination date, on the condition that ESBT elections for all six trusts are filed within 120 days. If that condition is not met, the ruling is void and the corporation must report that its S election terminated. The IRS expressed no view on whether the corporation is otherwise eligible to be an S corporation. Anyone whose S corporation status was accidentally broken by missed trust elections would recognize this common cure.

Ruling snapshot

• Question: Was the termination of the S corporation election (from six trusts' missed ESBT elections) an inadvertent termination the IRS will excuse under § 1362(f)?
• Outcome: Approved (S status treated as continuing, contingent on filing the ESBT elections within 120 days)
• Key authorities: IRC §§ 1362(f), 1362(d)(2), 1361(e) (ESBT); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201852002                                              Third Party Communication: None
Release Date: 12/28/2018                                       Date of Communication: Not Applicable
Index Number: 1362.01-00, 1362.01-00
                                                               Person To Contact:
----------------------------------                             ------------------------------,
-----------------------------------------------                ID No. ----------------
------------------------                                       Telephone Number:
------------------------------------------                     ----------------------
                                                               Refer Reply To:
                                                               CC:PSI:B01
                                                               PLR-108885-18
                                                               Date:
                                                               September 21, 2018

LEGEND

X                          =         ----------------------------------------------
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Trust 1                    =         --------------------------------------------------------------------------------
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Trust 2                    =         --------------------------------------------------------------------------------
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Trust 3                    =         --------------------------------------------------------------------------------
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Trust 4                    =         --------------------------------------------------------------------------------
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Trust 5                    =         --------------------------------------------------------------------------------
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Trust 6                    =         --------------------------------------------------------------------------------
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State                      =        -------

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

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

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

       This responds to a letter dated March 14, 2018, and supplemental information,
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
incorporated on Date 1, under the laws of State. Effective Date 1, X elected to be taxed
as an S corporation. However, a valid Electing Small Business Trust (ESBT) election
effective Date 2 was not made for Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, and Trust 6,
each a shareholder of X. Accordingly, Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, and
Trust 6 were ineligible shareholders of X and X's S corporation terminated on Date 2.

       X represents that X and its shareholders have treated X as an S corporation at all
relevant times. X further represents that each Trust 1, Trust 2, Trust 3, Trust 4, Trust 5,
and Trust 6 has filed its income tax returns consistent with being an ESBT. X represents
that the failure to file a valid ESBT election for Trust 1, Trust 2, Trust 3, Trust 4, Trust 5,
and Trust 6 was inadvertent and was not motivated by tax avoidance or retroactive tax
planning. Further, X represents that X and its shareholders agree to make any
adjustments (consistent with the treatment of X as an S corporation) that may be
required by the Secretary.

Law and Analysis

       Section 1361(a)(1) of the Code 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 1361(c)(2)(A)(v) provides that, for purposes of § 1362(b)(1)(B), an
electing small business trust (ESBT) may be an S corporation shareholder.

        Section 1361(e) provides that 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.

        Section 1361(e)(1)(B) provides that the term "electing small business trust" shall
not include (i) any qualified subchapter S trust (as defined in § 1361(d)(3)) if an election
under § 1361(d)(2) applies to any corporation the stock of which is held by such trust,
(ii) any trust exempt from tax under subtitle A, and (iii) any charitable remainder annuity
trust or charitable remainder unitrust (as defined in § 664(d)).

       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(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) or was terminated under § 1362(d)(2) or (3); (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 election was made or termination occurred is a small business corporation;
and (4) the corporation for which the election was made or 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.

Conclusion

       Based solely on the facts submitted and the representations made, we conclude
that X's S election terminated on Date 2 because of the failure to file a valid ESBT
election for Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, and Trust 6. We further conclude
that the termination of X's S election was inadvertent within the meaning of § 1362(f).
Therefore, X will be treated as an S corporation effective Date 2 and thereafter,
provided X's S corporation election is otherwise valid and not 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 Trust 1, Trust 2, Trust 3, Trust 4, Trust 5, and Trust 6 as an
ESBT effective Date 2 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 its 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 representatives.

                                           Sincerely,

                                           Faith P. Colson

                                           Faith P. Colson
                                           Senior Counsel, Branch 1
                                           Office of Associate Chief Counsel
                                           (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy of this letter for section 6110 purposes