S corporation received passive-income termination relief

Plain-English summary

An S corporation had accumulated earnings and profits from C corporation years and received more than 25 percent of its gross receipts from passive investment income for three consecutive years. Those conditions terminated its S election at the start of the next tax year. The IRS found the termination inadvertent and allowed the corporation to continue as an S corporation. Within 120 days, the corporation had to file an amended return electing a deemed dividend distribution of the accumulated amount, and its shareholders had to amend their returns consistently. The ruling became void if those conditions were not met.

Ruling snapshot

• Question: May the corporation retain S status after three years of excess passive investment income while holding accumulated C corporation earnings and profits?
• Outcome: approved, subject to a deemed dividend election and amended returns within 120 days
• Key authorities: IRC §§ 1362(d)(3), 1362(f), 1368, and 1375; Treas. Reg. § 1.1368-1(f)(3)

Full text (IRS public release)

Internal Revenue Service                                 Department of the Treasury
                                                         Washington, DC 20224

Number: 201935006                                        Third Party Communication: None
Release Date: 8/30/2019                                  Date of Communication: Not Applicable
Index Numbers: 1362.00-00, 1362.02-00,
              1362.02-03, 1362.04-00                     Person To Contact:
                                                         ----------------------, ID No. ------------------
----------------------------------                       Telephone Number:
--------------------------------------------             ----------------------
-----------------------------------                      Refer Reply To:
-----------------------------------------                CC:PSI:B03
                                                         PLR-131926-18
                                                         Date:
                                                         May 29, 2019




                                               LEGEND

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

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

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

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

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

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

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

Date 6         = ----------------------

Date 7         = ---------------------------

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



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

This letter responds to a letter dated October 16, 2018, and subsequent
correspondence, submitted on behalf of Company by Company’s authorized
PLR-131926-18                                  2

representative, requesting a ruling under § 1362(f) of the Internal Revenue Code
(Code).

                                           FACTS

According to the information submitted, Company was incorporated under the laws of
State on Date 1 and elected to be treated as an S corporation effective Date 2. At the
close of three consecutive taxable years ending Date 5, Company had subchapter C
accumulated earnings and profits of $a. Moreover, for each taxable year ending Date 3,
Date 4, and Date 5, 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 6.

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
PLR-131926-18                                 3

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 6, under § 1362(d)(3)(A)
because Company had subchapter C earnings and profits at the close of each of three
consecutive taxable years ending on Date 5, 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 6, 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. Within 120 days from the date of this letter, Company
shall file an amended return for its taxable year ending Date 7, electing pursuant to
§ 1.1368-1(f)(3) to make a deemed dividend distribution of $a. Also within 120 days of
this letter, Company’s shareholders shall amend their individual income tax returns
ending Date 7 to reflect the changes made to Company’s tax return ending Date 7. If
these conditions are not met, then this ruling is null and void. Furthermore, if these
conditions are not met, Company must notify the service center with which its S
corporation election was filed that its election terminated on Date 6. Based on the
particular facts of this case, no adjustments are required under § 1362(f)(4).

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) provides that
it may not be used or cited as precedent.
PLR-131926-18                                4

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

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,

                                             Associate Chief Counsel
                                             (Passthroughs & Special Industries)



                                         By:_____________________________
                                            Caroline E. Hay
                                            Assistant to the Branch Chief, Branch 3
                                            Office of the Associate Chief Counsel
                                            (Passthroughs & Special Industries)



Enclosures: Copy of this letter
            Copy of this letter for § 6110 purposes


cc: