IRS excuses an S corporation's ineligible partnership shareholder

Plain-English summary

An S corporation sold an ownership interest to an LLC that was treated as a partnership for federal tax purposes. Because a partnership cannot be an S corporation shareholder, the sale terminated the corporation's S election. After discovering the problem, the LLC distributed its entire interest to an individual who was an eligible shareholder. The corporation represented that the termination was inadvertent, was not motivated by tax avoidance or retroactive planning, and that all affected parties would make any required adjustments. The IRS granted inadvertent-termination relief and treated the corporation as continuously maintaining its S status, assuming the election was otherwise valid and had not otherwise terminated.

Ruling snapshot

• Question: Could the corporation retain continuous S status after an interest was temporarily held by an ineligible partnership shareholder?
• Outcome: Approved as an inadvertent termination.
• Key authorities: IRC §§ 1361(a) and (b), and 1362(d)(2) and (f)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202126004 Third Party Communication: None
Release Date: 7/2/2021 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-00,
1362.01-01, 1362.02-00, Person To Contact:
1362.04-00 ------------------------, ID No. -----------------
Telephone Number:
------------------------- --------------------
------------------------- Refer Reply To:
------------------------------- CC:PSI:B01
---------------------------------- PLR-122792-20
Date:
November 23, 2020

Legend

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

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

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

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

Y = --------

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

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

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

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

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

This letter responds to a letter dated September 11, 2020, submitted on behalf of X by
its authorized representatives, requesting inadvertent termination relief under § 1362(f)
of the Internal Revenue Code (Code).

Facts
PLR-122792-20 2

The information submitted discloses that X was formed under the laws of State and
elected to be an S corporation effective Date 1.

On Date 2, Y% of the total interest in X was sold to LLC, a partnership for federal tax
purposes. LLC, as a partnership, was an ineligible shareholder of an S corporation. On
or about Date 3, X learned that the sale of interest to LLC terminated X’s S election. On
Date 4, X and its shareholders took remedial action by having LLC distribute all its
interest in X to A, an individual. X represents that A is an eligible S corporation
shareholder.

X represents that the circumstances resulting in the termination of X’s S corporation
election were inadvertent and not motivated by tax avoidance or retroactive tax
planning. X further represents that X and its shareholders have agreed to make any
adjustments 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 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 § 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 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 taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation.

Section 1362(f) provides that if (1) an election under subsection (a) or section
1361(b)(3)(B)(ii) by any corporation (A) was not effective for the taxable year for which
made (determined without regard to subsection (b)(2)) by reason of a failure to meet the
requirements of section 1361(b) or to obtain shareholder consents, or (B) was
terminated under paragraph (2) or (3) of subsection (d) or section 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 such 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,
PLR-122792-20 3

and each person who was a shareholder in such corporation at any time during the
period specified pursuant to this subsection, agrees 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 information submitted and the representations made, we conclude
that X’s S election terminated on Date 2 when an interest in X was issued to LLC. We
further conclude that the termination was inadvertent within the meaning of § 1362(f).
Accordingly, under § 1362(f), X will be treated as continuing to be an S corporation on
and after Date 2, provided that X’s S corporation election was valid and not otherwise
terminated under § 1362(d).

Except as specifically ruled above, we express or imply no opinion as to the federal
income tax consequences of the facts described above under any other provision of the
Code. Specifically, no opinion is expressed concerning whether X is a subchapter S
corporation for federal income tax purposes.

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.

The ruling contained in this letter is based on 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.
PLR-122792-20 4

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to X’s authorized representatives.

Sincerely,

Laura C. Fields
Senior Technician Reviewer, Branch 1
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy of this letter for section 6110 purpose

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