S corporation's inadvertent termination is excused after a trust beneficiary missed the QSST election

Plain-English summary

A corporation had elected to be taxed as an S corporation, the pass-through regime that avoids corporate-level tax. Its shares were later transferred to a trust. A trust can only hold S corporation stock if it fits one of the narrow categories the law allows, and here the trust qualified as a "qualified subchapter S trust" (QSST), but that treatment requires the trust's beneficiary to affirmatively file a QSST election. The beneficiary inadvertently failed to make that election, which meant the corporation briefly had an ineligible shareholder and its 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 everyone agrees to conforming tax treatment. The IRS agreed: it found the termination inadvertent and ruled the corporation will be treated as continuing to be an S corporation, as long as the beneficiary files the QSST election effective the transfer date within 120 days. The IRS did not decide whether the company otherwise qualifies as a small business corporation or whether the trust is truly a QSST. Anyone whose S corporation status was accidentally broken by a missed trust election would recognize this standard fix.

Ruling snapshot

• Question: Was the termination of the S corporation election (from a missed QSST election) an inadvertent termination that the IRS will excuse under § 1362(f)?
• Outcome: Approved (S status treated as continuing, contingent on filing the QSST election within 120 days)
• Key authorities: IRC §§ 1362(f), 1362(d)(2), 1361(d) (QSST); Treas. Reg. § 1.1361-1(j)(6)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201852003                                              Third Party Communication: None
Release Date: 12/28/2018                                       Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                               Person To Contact:
-------------------------------------                          --------------------, ID No. --------------
--------------------------------                               Telephone Number:
------------------------                                       ----------------------
---------------------------------                              Refer Reply To:
                                                               CC:PSI:B03
                                                               PLR-109751-18
                                                               Date:
                                                               September 20, 2018

X                 =         -------------------------------------
---------------------------------------------------
State             =        ---------------------
D1                =        --------------------
D2                =        ----------------------------
Trust             =         -----------------------------------------------------------------------------------------
                  ---------------------------------------------------------------------------------------------------
                  -----
                           ---------------
 -------------------------------------------------
Dear ------ -----------:

       This responds to a letter dated March 23, 2018, submitted on behalf of X by its
authorized representative, requesting a ruling under § 1362(f) of the Internal Revenue
Code.

       The information submitted states that X was incorporated under the laws of State
and elected to be an S corporation effective on D1. On D2, shares of X were
transferred to Trust.

       X represents that Trust was eligible to elect qualified subchapter S trust (QSST)
treatment under § 1361(d). However, the beneficiary of Trust inadvertently failed to
timely make a QSST election. Therefore, X's S election terminated on D2.

       X represents that X and each of its shareholders have filed consistently with the
treatment of X as an S corporation since D1. X represents that the termination was not
motivated by tax avoidance or retroactive tax planning. X and its shareholders have
agreed to make any adjustments that the Commissioner may require, consistent with
the treatment of X as an S corporation.

       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)(B) provides that 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)(i) provides that, for purposes of § 1361(b)(1)(B), a trust all
of which is treated (under subpart E of part I of subchapter J of chapter 1) as owned by
an individual who is a citizen or resident of the United States may be an S corporation
shareholder.

       Section 1361(d)(1) provides that in the case of a QSST for which a beneficiary
makes an election under § 1361(d)(2), the trust is treated as a trust described in
§ 1361(c)(2)(A)(i), and for purposes of § 678(a), the beneficiary of the trust shall be
treated as the owner of that portion of the trust that consists of stock in an S corporation
with respect to which the election under § 1361(d)(2) is made.

       Section 1361(d)(2)(A) provides that a beneficiary of a QSST may elect to have
§ 1361(d) apply. Section 1.1361-1(j)(6)(ii) provides that the current income beneficiary
of a QSST must make the election under § 1361(d)(2) by signing and filing with the
service center with which the corporation files its income tax returns the applicable form
or a statement including the information listed in § 1.1361-1(j)(6)(ii).

       Section 1362(d)(2) provides that (A) in general, an election under § 1362(a) shall
be terminated whenever (at any time on or after the first day of the first taxable year for
which the corporation is an S corporation) such corporation ceases to be a small
business corporation, and (B) any termination under § 1362(d)(2) shall be effective on
and after the date of cessation.

        Section 1362(f) provides, in part, that if (1) an election under § 1362(a) by any
corporation (A) 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 to obtain shareholder consents or (B) was terminated under § 1362(d)(2)
or (3), (2) the Secretary determines that the circumstances resulting in the
ineffectiveness or termination were inadvertent, (3) no later than a reasonable period of
time after discovery of the circumstances resulting in the ineffectiveness or termination,
steps were taken (A) so that the corporation is a small business corporation or (B) to
acquire the shareholder consents, and (4) the corporation and each person who was a
shareholder of the corporation at any time during the period specified pursuant to
§ 1362(f), agrees to make such adjustments (consistent with the treatment of the
corporation as an S corporation) as may be required by the Secretary with respect to
such period, then, notwithstanding the circumstances resulting in the ineffectiveness or
termination, the corporation will be treated as an S corporation during the period
specified by the Secretary.

       Based solely on the facts submitted and the representations made, we conclude
that X's S corporation election terminated on D2, because of the inadvertent failure of
the beneficiary of Trust to make a QSST election, and that this termination of X's S
election was an inadvertent termination within the meaning of § 1362(f). Accordingly,
pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S
corporation from D2 and thereafter, provided X's S corporation election was valid and
not otherwise terminated under § 1362(d).

        This ruling is contingent upon the beneficiary of Trust filing a QSST election, with
an effective date of D2, with the appropriate service center within 120 days of the date
of this ruling. A copy of this letter should be attached to the QSST election. If X or its
shareholders fail to treat X as described above, this letter ruling will be null and void.

       Except as specifically set forth above, no opinion is expressed concerning the
federal tax consequences of the facts described above under any other provision of the
Code, including whether X is a small business corporation under § 1361(b), or whether
Trust is a QSST within the meaning of § 1361(d)(3).

       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.

        This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
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 X's authorized representative.

                                       Sincerely,

                                      Stacy L. Short
                                      Senior Technician Reviewer, Branch 3
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)
Enclosures: 2
         Copy of this letter
         Copy for § 6110 purposes