S corporation keeps status after its shareholder became a partnership

Plain-English summary

An S corporation's shares were held by a disregarded entity owned by an eligible shareholder. When that disregarded entity later became a partnership for federal tax purposes, it became an ineligible S corporation shareholder and terminated the corporation's S election. After discovering the problem, the parties transferred the shares to the eligible owner and allocated later income and other items to that owner. The corporation represented that the termination was inadvertent and unrelated to tax avoidance or retroactive planning. The IRS granted section 1362(f) relief and treated the corporation as continuously maintaining S status, assuming the election was otherwise valid. For the problem period, the partnership was treated as the shareholder, and the relevant shareholders had to report items, basis adjustments, and distributions under sections 1366 through 1368.

Ruling snapshot

• Question: Could the corporation retain S status after a disregarded shareholder became an ineligible partnership?
• Outcome: Approved as an inadvertent termination after corrective transfer of the shares.
• Key authorities: IRC §§ 1361(b), 1362(d), 1362(f), and 1366 through 1368

Full text (IRS public release)

Internal Revenue Service                                         Department of the Treasury
                                                                 Washington, DC 20224

Number: 201922003                                                Third Party Communication: None
Release Date: 5/31/2019                                          Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-00,
              1362.02-00                                         Person To Contact:
                                                                 ----------------------------,
-------------------------------                                  ID No. ---------------
------------------------------------                             Telephone Number:
--------------------------------                                 ---------------------
----------------------------                                     Refer Reply To:
                                                                 CC:PSI:B01
                                                                 PLR-103520-18
                                                                 Date:
                                                                 February 25, 2019

LEGEND

X                 =         ----------------------------------
--------------------------------------------------

Y                 =         -----------------------
--------------------------------------------------

A                 =        ---------------------

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

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

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

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

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




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

        This responds to a letter dated October 25, 2017, and supplemental
correspondence, submitted on behalf of X, by X's authorized representative, requesting
relief under § 1362(f) of the Internal Revenue Code (the Code).
PLR-103520-18                                 2


Facts

        According to the information submitted and representations made within, X was
formed under the laws of State and made an S election effective Date 1. On Date 2, all
of the shares in X were transferred to Y, a disregarded entity wholly owned by A, an
eligible S corporation shareholder. On Date 3, Y became a partnership for federal tax
purposes. Y, as a partnership, was an ineligible shareholder of an S corporation. On
Date 4, X discovered that Y was an ineligible shareholder that caused X’s S election to
terminate effective Date 3. On Date 4, X and its shareholders took remedial action by
having Y transfer all of its shares in X to A, an eligible S corporation shareholder. After
Date 4, all income and other items from the X shares were allocated to A.

       X represents that the circumstances resulting in the termination of X's S
corporation election were inadvertent and not motivated by tax avoidance or retroactive
tax planning. X further represents that it has filed returns consistent with its status as an
S corporation. X and its shareholders have agreed to make any adjustments the
Commissioner may require, consistent with the treatment of X as an S corporation.

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 the 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 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 subsection (a) or section
1361(b)(3)(B)(ii) by any corporation (A) was not effective for the taxable year for which
made (determined without regard to subsection (b)(2)) by reason of a failure to meet the
requirements of section 1361(b) or to obtain shareholder consents, or (B) was
terminated under paragraph (2) or (3) of subsection (d) or section 1361(b)(3)(C); (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 (A) so that the corporation for which the election was made or the
PLR-103520-18                                3

termination occurred is a small business corporation or a qualified subchapter S
subsidiary, as the case may be, or (B) to acquire the required shareholder consents;
and (4) the corporation for which the election was made or the termination occurred,
and each person who was a shareholder in such corporation at any time during the
period specified pursuant to this subsection, agrees to make such adjustments
(consistent with the treatment of such corporation as an S corporation or a qualified
subchapter S subsidiary, as the case may be) 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 or
a qualified subchapter S subsidiary, as the case may be during the period specified by
the Secretary.

Conclusion

      Based solely on the information submitted and the representations made, we
conclude that X's S election terminated on Date 3 because X had an ineligible
shareholder. We further conclude that the termination was inadvertent within the
meaning of § 1362(f).

       Accordingly, under § 1362(f), X will be treated as continuing to be an S
corporation on and after Date 3, provided that X's S corporation election was valid and
not otherwise terminated under § 1362(d).

        Y will be treated as the shareholder of X from Date 2 until Date 4, at which point
A will be treated as the shareholder. Accordingly, the shareholders of X must include in
income their pro rata share of the separately stated and nonseparately computed items
of X as provided in § 1366, make any adjustments to basis as provided in § 1367, and
take into account any distributions made by X as provided in § 1368.

       Except as specifically ruled above, we express or imply no opinion as to the
federal income tax consequences of the facts described above under any other
provision of the code, including whether X was otherwise a valid S corporation.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.
PLR-103520-18                                 4

        Pursuant to the power of attorney on file with this office, we are sending a copy of
this letter to X's authorized representative.


                                          Sincerely,


                                          David R. Haglund
                                          David R. Haglund
                                          Branch Chief, Branch 1
                                          Office of Associate Chief Counsel
                                          (Passthroughs & Special Industries)



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