S corporation termination from missed ESBT election treated as inadvertent

Plain-English summary

A trust acquired shares of an S corporation but its trustees did not timely elect for the trust to be treated as an electing small business trust. That failure made the trust an ineligible shareholder and terminated the corporation's S election. The corporation and its shareholders continued to treat the company as an S corporation, while the trust did not file consistently with ESBT status. The IRS found that the termination was inadvertent and allowed the corporation to remain an S corporation from the termination date. The relief required a retroactive ESBT election and consistent original or amended returns within 120 days, plus payment of a redacted amount within 45 days.

Ruling snapshot

• Question: May the corporation continue as an S corporation after a trust shareholder failed to make a timely ESBT election?
• Outcome: approved, subject to a timely corrective ESBT election, consistent returns, and the required payment
• Key authorities: IRC §§ 1361(c)(2), 1361(e), 1362(d)(2), and 1362(f); Treas. Reg. §§ 1.1361-1(m) and 1.1362-4

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201943018                                              Third Party Communication: None
Release Date: 10/25/2019                                       Date of Communication: Not Applicable
Index Number: 1362.04-00
                                                               Person To Contact:
-----------------------------------                            ---------------------------, ID No. ---------------
------------------                                             -----------------
-----------------------------                                  Telephone Number:
--------------------------------------                         ----------------------
                                                               Refer Reply To:
                                                               CC:PSI:B03
                                                               PLR-135434-18
                                                               Date:
                                                               July 10, 2019


                                                       LEGEND

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

Trust             =         -----------------------------------------------------------------
                           -------------------------

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

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

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

Years             =        -------------------

n                 =        ----------------


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

This responds to a letter dated December 4, 2018, and subsequent correspondence,
submitted on behalf of X by its authorized representative, requesting a ruling under
§ 1362(f) of the Internal Revenue Code.

                                                       FACTS

The information submitted states that X is a State corporation that elected to be treated
as an S corporation effective as of Date 1. On Date 2, Trust acquired shares of X. X
represents that Trust has at all times since Date 2 satisfied the requirements of an
electing small business trust (ESBT) except that the trustees of Trust did not make a
PLR-135434-18                                 2

timely ESBT election under §1361(e)(3). Accordingly, Trust was not an eligible S
corporation shareholder as of Date 2, thereby causing X’s S corporation election to
terminate on Date 2.

X represents that X and its shareholders have treated X as an S corporation at all
relevant times, and that Trust has received a K-1 from X for Years but that Trust did not
file its returns consistent with being an ESBT.

X represents that the termination of its S corporation election was inadvertent and 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.

                                  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 1361(b)(1)(B) provides that, for purposes of subchapter S, 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)(v) provides that, for purposes of § 1362(b)(1)(B), an ESBT may
be an S corporation shareholder.

Section 1361(e)(1)(A) 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)(2), (3), (4), or (5), or (IV) 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 an ESBT does 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
PLR-135434-18                                 3

and all subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

Section 1.1361-1(m)(2)(i) provides, in part, 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(d)(2)(A) provides that an election under § 1362(a) will be terminated
whenever (at any time on or after the 1st day of the 1st taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

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 the
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 of such 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 such termination, the corporation will be treated as an S
corporation during the period specified by the Secretary.

Section 1.1362-4(b) provides, in relevant part, that for purposes of § 1.1362-4(a), the
determination of whether a termination was inadvertent is made by the Commissioner.
The corporation has the burden of establishing that under the relevant facts and
circumstances the Commissioner should determine that the termination was
inadvertent. The fact that the terminating event was not reasonably within the control of
the corporation and was not part of a plan to terminate the election, or the fact that the
terminating event or circumstance took place without the knowledge of the corporation,
notwithstanding its due diligence to safeguard itself against such an event or
circumstance, tends to establish that the termination was inadvertent.

Section 1.1362-4(d) provides, in part, that the Commissioner may require any
adjustments that are appropriate. In general, the adjustments should be consistent with
the treatment of the corporation as an S corporation during the period specified by the
Commissioner.
PLR-135434-18                                 4


                                      CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 2 due to the trustees’ failure to make an
ESBT election for Trust. We also conclude that the termination was inadvertent within
the meaning of § 1362(f). We further hold that, pursuant to the provisions of § 1362(f),
X will be treated as continuing to be an S corporation from Date 2, provided X’s S
corporation election was valid and provided that the election was not otherwise
terminated under § 1362(d).

This letter ruling is subject to the following conditions. No later than 120 days from the
date of this letter: (1) an election to treat Trust as an ESBT, effective Date 2, must be
made with the appropriate service center; and (2) X and each of its shareholders must
file any original and amended returns for all open taxable years consistent with the relief
granted in this letter. A copy of this letter should be attached to the ESBT election. If
these conditions are not met, then this ruling is null and void.

Furthermore, as an adjustment under § 1362(f), no later than 45 days from the date of
this letter a payment of $n and a copy of this letter ruling must be sent to the following
address:

Internal Revenue Service
Kansas City Service Center
333 W. Pershing Road
Kansas City, MO 64108
Stop 7777
Manual Deposit

If X or its shareholders fail to treat themselves as described above or if these conditions
are not met, this ruling is null and void. Furthermore, if these conditions are not met, X
must send notification that its S election has terminated to the service center with which
X’s S election was filed.

Except as specifically ruled above, we express no opinion concerning the federal tax
consequences of the transactions described above under any other provisions 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 that requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.
PLR-135434-18                                 5

Pursuant to a power of attorney on file, copies of this letter are being sent to X’s
authorized representative.



                                       Sincerely,



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


Enclosures: 2
      Copy of this letter
      Copy for § 6110 purposes



cc: