IRS validates an S election made with an ineligible shareholder

Plain-English summary

A corporation elected S status while one shareholder was an entity that could not hold S corporation stock, making the election ineffective. The corporation and its shareholders did not know of the eligibility problem. After discovering it, the ineligible shareholder promptly liquidated and distributed its shares to owners who were eligible S corporation shareholders. The parties had consistently filed and reported items as though the election were effective and agreed to make any required adjustments. The IRS found the failure inadvertent under IRC § 1362(f) and treated the corporation as an S corporation from the original election date forward, provided the election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Was the S election's ineffectiveness from an ineligible shareholder inadvertent under § 1362(f)?
• Outcome: Approved. The corporation is treated as an S corporation from the original election date.
• Key authorities: IRC §§ 1361 and 1362(f)

Full text (IRS public release)

 Internal Revenue Service                                         Department of the Treasury
                                                                  Washington, DC 20224

 Number: 202103009                                                Third Party Communication: None
 Release Date: 1/22/2021                                          Date of Communication: Not Applicable
 Index Numbers: 1362.00-00, 1362.04-00
                                                                  Person To Contact:
 --------------------------------------------------               ------------------------, ID No. -----------------
 -------------------------------------------                      Telephone Number:
 ----------------------                                           --------------------
 --------------------------------------                           Refer Reply To:
                                                                  CC:PSI:B03
                                                                  PLR-110911-20
                                                                  Date:
                                                                  October 28, 2020




LEGEND

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

P                 =         -----------------------------------
---------------------------------------------------

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

Date1             =        -----------------------

Date2             =        -----------------



Dear -----------------

       This letter responds to a letter dated April 29, 2020, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
a ruling under § 1362(f) of the Internal Revenue Code (“Code”).

                                                      FACTS

      The information submitted states that X, a State corporation, elected to be an S
corporation effective Date1. X represents that when this election was filed, X and its
shareholders were not aware that one of its shareholders, P, was an ineligible S
corporation shareholder and therefore X’s S corporation election was ineffective. X
represents that soon after X and its shareholders discovered this error, P liquidated on
Date 2 and distributed its shares in X to P’s owners, all of whom are eligible S
corporation shareholders.


       X represents that X and its shareholders have filed tax returns consistent with X
being an S corporation since Date1 and that the owners of P have reported all items of
X consistent with X being an S corporation. Moreover, X and its shareholders represent
that the circumstances resulting in the ineffectiveness of X’s S corporation election were
inadvertent and were not motivated by tax avoidance or retroactive tax planning.
Finally, X and each person who was or is a shareholder of X at any time since Date1
agree to make any adjustments (consistent with the treatment of X as an S corporation)
as may be required by the Secretary with respect to such period.

                                  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) 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
one class of stock.

      Section 1362(a)(1) 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(d)(2) provides that an election under § 1362(a) shall be terminated
whenever (at any time on or after the first day of the first taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation. A termination of an S corporation election under § 1362(d)(2) is effective
on and after the date of cessation.

        Section 1362(f) provides that if (1) an election under § 1362(a) or
§ 1361(b)(3)(B)(ii) 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) or § 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
the ineffectiveness or termination, steps were taken (A) so that the corporation for which
the election was made or the 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 § 1362(f), agree 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 facts submitted and the representations made, we conclude
that X’s S corporation election was ineffective on Date1 because P was an ineligible S
corporation shareholder. We further conclude that the circumstances resulting in the
ineffectiveness were inadvertent within the meaning of § 1362(f). Pursuant to the
provisions of § 1362(f), X will be treated as an S corporation effective Date1 and
thereafter, provided that X’s S corporation election was otherwise valid and has not
otherwise terminated under § 1362(d).

         Except as expressly provided herein, we express or imply no opinion concerning
the federal tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion regarding X’s
eligibility to be an S corporation.

       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.

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

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


                                     Sincerely,

                                     Mary Beth Carchia
                                     Senior Technician Reviewer, Branch 3
                                     Office of Associate Chief Counsel
                                     (Passthroughs & Special Industries)

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

cc: