IRS grants relief for an inadvertent S corporation termination

Plain-English summary

An S corporation had a shareholder that was a limited liability company owned through trusts created by a married couple in a community-property state. After interests in the LLC were sold to additional trusts, the interests were no longer all community property and the LLC became a partnership for federal tax purposes. That made the LLC an ineligible S corporation shareholder and terminated the corporation's S election. The parties discovered the problem, took corrective steps, consistently filed as an S corporation, and agreed to make any required adjustments. The IRS found the termination inadvertent under IRC § 1362(f) and treated the corporation as an S corporation from the termination date, assuming its election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Was the S election's termination from an LLC becoming an ineligible shareholder inadvertent under § 1362(f)?
• Outcome: Approved. The corporation remains treated as an S corporation from the termination date.
• Key authorities: IRC §§ 1361 and 1362(f); Rev. Proc. 2002-69

Full text (IRS public release)

 Internal Revenue Service                                         Department of the Treasury
                                                                  Washington, DC 20224

 Number: 202103001                                                Third Party Communication: None
 Release Date: 1/22/2021                                          Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.04-00
                                                                  Person To Contact:
 ----------------------------------------------------             -----------------------, ID No. -----------------
 ---------------------------------------------                    Telephone Number:
 --------------------                                             --------------------
 -----------------------------------                              Refer Reply To:
                                                                  CC:PSI:03
                                                                  PLR-105472-20
                                                                  Date:
                                                                  August 28, 2020

Legend


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

LLC                        =         ---------------------------------------
------------------------------------------------------------

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

B                          =        -------------------

C                          =        ------------------------

D                          =        ---------------------------

LP 1                       =        -------------------------------------------

LP 2                       =        -------------------------------------------

Trust 1                    =        ------------------------------

Trust 2                    =        ----------------------------------------------

Trust 3                    =        --------------------------------------------------

Trust 4                    =        ----------------------------------------------------------

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

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

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

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

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

State 1              =     -------------

State 2              =     --------

a                    =     ---

b                    =     ---

c                    =     ---

d                    =     ---

e                    =     ---

f                    =     ---

g                    =     ---


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

      This letter responds to a letter dated December 19, 2019 submitted on behalf of
X requesting relief under section 1362(f) of the Internal Revenue Code (the Code).

                                                Facts

      According to the information submitted and representations made within, X was
incorporated on Date 1, under the laws of State 1, and made a valid S election effective
Date 2.

       Immediately prior to Date 3, X was owned by the following eligible shareholders:
a% by LP 1, b% by C and D, a husband and wife, c% by LLC, and d% by LP 2. Also
immediately prior to Date 3, LLC was wholly owned by Trust 1, also an eligible
shareholder. A and B, a husband and wife, were the co-grantors and co-trustees under
the laws of State 2, a community property state, of Trust 1.

       On Date 3, Trust 1 sold the following issued and outstanding membership
interest in LLC: e% to Trust 4, f% to Trust 3, and g% to Trust 2. Property owned by
Trust 2, Trust 3, and Trust 4 did not qualify as community property with respect to A and

B under State 2 law. As a result of the sale, LLC became regarded as a partnership for
federal income tax purposes on Date 3, because the LLC interest held by Trust 2, Trust
3, and Trust 4 were no longer community property owned by A and B.

       On Date 4, X discovered that LLC had been an ineligible shareholder and that
had caused X’s S election to terminate effective Date 3. Thereafter, Date 5, X, A, B,
Trust 1, Trust 2, Trust 3, and Trust 4 made corrective steps to ensure the corporation
only had eligible shareholders.

       X represents that if its S corporation election terminated it was inadvertent and
was not motivated by tax avoidance or retroactive tax planning. X also represents that
X and its shareholders agree to make any adjustments required as a condition of
obtaining relief under the inadvertent termination rule as provided under § 1362(f) of the
Code that may be required by the Secretary. X further represents that X and its
shareholders have filed consistently with X continuing to be a valid 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 subsection (c)(2), or an organization described in subsection (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 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) the Secretary determines that the
circumstances resulting in the termination were inadvertent, (3) no later than a
reasonable period of time after the 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 in such corporation at any time
during the period of inadvertent termination of the S election, agrees to makes 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 termination, the corporation shall be treated as an S
corporation during the period specified by the Secretary.

       Rev. Proc. 2002-69, 2002-2 C.B. 831, provides guidance on the classification of
a business entity owned by a husband and wife as community property. If the husband
and wife treat a qualified entity as a disregarded entity for federal income tax purposes,
the Service will respect that treatment. If the husband and wife treat a qualified entity as
a partnership for federal income tax purposes and file the appropriate partnership
returns, the Service will respect that treatment. A change in reporting position will be
treated as a conversion of the entity. A business entity is a qualified entity if (1) it is
wholly owned by a husband and wife as community property under the laws of a state, a
foreign country, or a possession of the United States; (2) no person other than one or
both spouses would be considered an owner for federal tax purposes; and (3) the
business entity is not treated as a corporation under § 301.7701-2.

                                        Conclusion

       Based solely on the facts submitted and representations made, we conclude the
existence of an ineligible shareholder under § 1361(b)(1)(B) caused X's S election to
terminate on Date 3. We further conclude that the circumstances resulting in the
termination on Date 3 were inadvertent within the meaning of § 1362(f). Accordingly,
under § 1362(f), X will be treated as an S corporation from Date 3, provided X's S
corporation election was otherwise valid and has not otherwise terminated under
§ 1362(f).

       Except as specifically ruled above, we express or imply no opinion concerning
the federal 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 that requested it. Section 6110(k)(3)
of the Code provides that it may not be used or cited for precedent.

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

       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 rulings requested, it is subject to verification on examination.


                                                 Sincerely,


                                                 By: ______________________________
                                                 Richard T. Probst
                                                 Senior Technician Reviewer, Branch 3
                                                 Office of the Associate Chief Counsel
                                                 (Passthroughs & Special Industries)


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



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