IRS validates S status after an IRA improperly held corporate shares

Plain-English summary

A shareholder used IRA funds to acquire a corporation's shares, but the IRA trustee bought and held the stock directly instead of distributing funds to the individual. The corporation's later S election was therefore invalid because the IRA was not an eligible shareholder. The corporation and two shareholders generally filed and paid tax as though the election were effective, and the IRA eventually distributed the shares to the individual. The IRS found the invalid election inadvertent and treated the corporation as an S corporation from the intended date. Relief was conditioned on the corporation and shareholders amending returns for one omitted tax year within 120 days, or else the ruling would be void and the corporation would have to notify the service center of termination.

Ruling snapshot

• Question: Could the corporation receive relief for an invalid S election caused by direct IRA ownership of its shares?
• Outcome: approved (S status was recognized, subject to amended-return conditions)
• Key authorities: IRC §§ 1361(b), 1362(a), 1362(f)

Full text (IRS public release)

 Internal Revenue Service                                        Department of the Treasury
                                                                 Washington, DC 20224

 Number: 202024001                                               Third Party Communication: None
 Release Date: 6/12/2020                                         Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.01-00,
               1362.02-00, 1362.04-00                            Person To Contact:
                                                                 --------------, ID No. -----------------
 --------------------------------------                          Telephone Number:
 --------------------------------------                          ---------------------
 ---------------------------------                               Refer Reply To:
 --------------------------                                      CC:PSI:B01
                                                                 PLR-118846-19
                                                                 Date:
                                                                 February 7, 2020



Legend

  X                                 ---------------------------------------
                         =          ----------------------
  Shareholder 1                     -----------------------
                         =
                                    -------------------------
  Shareholder 2                     -----------------------
                         =
                                    -------------------------
  Date 1                 =          --------------------------
  Date 2                 =          --------------
  Date 3                 =          ---------------------
  Date 4                 =          --------------------------
  Date 5                 =          --------------------
  State                  =          -----------

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

      This responds to a letter dated July 30, 2019, and supplemental correspondence
submitted on behalf of X by X’s authorized representatives, requesting inadvertent
termination relief under § 1362(f) of the Internal Revenue Code.

                                                      Facts

       According to the information submitted and representations made, X was
incorporated under the laws of State on Date 1. Shareholder 1 purchased the stock of X
using funds from Shareholder 1’s IRA on Date 2. Instead of taking a distribution from
the IRA and using the funds to purchase the shares, Shareholder 1’s IRA trustee
purchased and held the shares of X directly in the IRA.
PLR-118846-19                                2

        X made an election to be an S corporation effective Date 3. However, this S
election was invalid because Shareholder 1’s IRA was an ineligible shareholder. X
represents that since Date 3, Shareholder 1 and Shareholder 2 have filed and paid
taxes as if X was an S corporation. X further represents that X reported taxable income
on its filed federal income tax returns since Date 3 with the exception of the tax year
ended Date 4. X represents that Shareholder 1’s IRA distributed the shares of X to
Shareholder 1 on Date 5.

        X finally represents that X's election was inadvertently invalid on Date 3 and the
invalid election was not motivated by tax avoidance or retroactive tax planning. X and its
shareholders have agreed to make any adjustments required as a condition of obtaining
relief under the inadvertent termination rule of § 1362(f).

                                    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 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

        Section 1362(f) provides 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.
PLR-118846-19                                 3

                                        Conclusion

         Based solely on the facts submitted and the representations made, we conclude
that X’s S corporation election on Date 3 was invalid, and thus not effective. We also
conclude that this invalid election was inadvertent within the meaning of § 1362(f). We
hold that, pursuant to the provisions of § 1362(f), X will be treated as an S corporation
from Date 3 and thereafter, provided X’s S corporation election was otherwise valid and
provided that the election was not otherwise terminated under § 1361(b). This letter
ruling is subject to the following condition: No later than 120 days from the date of this
letter, the federal income tax returns filed for X, Shareholder 1 and Shareholder 2 for the
tax year ended Date 4 must be amended to report taxable income and pay taxes
accordingly. 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 X’s S election was filed.

       Except as specifically ruled above, we express no opinion concerning the federal
tax consequences of any transaction described above under any other provisions of the
Code.

      This ruling is directed only to the taxpayers requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

       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.

        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,

                                       Joy Spies
                                       Joy Spies
                                       Senior Technician Reviewer, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosures (2)

       Copy of Letter
       Copy for 6110 purposes

       cc: