An S corporation that tripped the passive-income termination rule gets inadvertent-termination relief, conditioned on paying the resulting tax

Plain-English summary

An S corporation had leftover earnings and profits from an earlier period as a regular C corporation, and for three straight years more than 25 percent of its gross receipts were passive investment income (such as rents, interest, and dividends). Under section 1362(d)(3), that combination automatically terminates a company's S corporation status. The company said its tax advisors never warned it about the passive-income rule, so the termination was accidental, and it asked the IRS for relief under section 1362(f), which lets the IRS disregard a termination it finds was inadvertent. The IRS granted relief and will treat the company as continuing to be an S corporation, but only on the condition that the company pays a specified amount (the tax triggered by the excess passive income) and sends a copy of the letter to a designated IRS campus within 45 days; if it does not, the ruling is void. This lets the company keep pass-through tax treatment rather than being taxed as a C corporation. (Note: the IRS indexed this ruling under the entity-classification and 9100 relief codes, but the letter actually addresses section 1362(f) S corporation relief.)

Ruling snapshot

• Question: Was the termination of the company's S corporation election, triggered by excess passive investment income with accumulated earnings and profits, inadvertent under § 1362(f)?
• Outcome: Approved (inadvertent termination; S corporation status continues, conditioned on a required payment within 45 days)
• Key authorities: IRC § 1362(f), § 1362(d)(3), § 1375; Treas. Reg. § 1.1362-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202144001 Third Party Communication: None
Release Date: 11/5/2021 Date of Communication: Not Applicable
Index Number: 7701.00-00, 9100.00-00,
9100.31-00 Person To Contact:
----------------, ID No. ----------
------------------------------------------------- Telephone Number:
------------------------ ---------------------
----------------------------------- Refer Reply To:
CC:PSI:01
PLR-100266-21
Date:
July 30, 2021

Legend

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

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

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

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

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

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

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

Date 6 = ---------------------

Date 7 = --------------------------

a = -------------

b = -------------

Dear --------------:
PLR-100266-21 2

This letter responds to a letter dated December 28, 2021, and subsequent
correspondence, submitted on behalf of X by X’s authorized representative, requesting
inadvertent termination relief under § 1362(f) of the Internal Revenue Code.

FACTS

The information submitted states that X is a corporation organized under the laws of
State on Date 1. X made an election to be an S corporation effective Date 2.

At the close of three consecutive taxable years ending Date 5, X had subchapter C
accumulated earnings and profits of $a. In addition, for each taxable year ending Date
3, Date 4, and Date 5, X had passive investment income (within the meaning of §
1362(d)(3)) in excess of 25 percent of its gross receipts. As a result, X’s S corporation
election terminated on Date 6. X distributed its subchapter C accumulated earnings and
profits on Date 7.

X represents that its tax advisors inadvertently failed to inform X of the passive
investment rules. In addition, X represents that the termination of X’s S corporation
election was inadvertent and not motivated by tax avoidance or retroactive planning. X
further represents that since Date 2, X and its shareholders have filed all returns
consistent with X’s status as an S corporation. X and its shareholders have agreed to
make such adjustments consistent with the treatment of X as an S corporation as may
be required by the Secretary.

LAW

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 1362(d)(3)(A)(i) provides that an election under § 1362(a) shall be terminated
whenever the corporation has accumulated earnings and profits at the close of each of
three consecutive taxable years, and has gross receipts for each of such taxable years
more than 25 percent of which are passive investment income.

Section 1362(d)(3)(A)(ii) provides that the termination under § 1362(d)(3) shall be
effective on and after the first day of the first taxable year beginning after the third
consecutive taxable year referred to in § 1362(d)(3)(A)(i).

Section 1362(d)(3)(C)(i) provides that the term “passive investment income” means,
except as otherwise provided in § 1362(d)(3), gross receipts derived from royalties,
rents, dividends, interest, and annuities.

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 §
PLR-100266-21 3

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 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 (B) to acquire the 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), 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
ineffectiveness or termination, such corporation shall be treated as an S corporation
during the period specified by the Secretary.

Section 1.1362-4(a) provides that a corporation is treated as continuing to be an S
corporation during the period specified by the Commissioner if (1) the corporation made
a valid election under § 1362(a) and the election terminated, (2) the Commissioner
determines that the termination was inadvertent, (3) within a reasonable period of time
after the discovery of the terminating event, steps were taken so that the corporation for
which the termination occurred is a small business corporation, and (4) the corporation
and shareholders agree to adjustments that the Commissioner may require for the
period.

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

Section 1375(a) provides that if for the taxable year an S corporation has (1)
accumulated earnings and profits at the close of such taxable year, and (2) gross
receipts more than 25 percent of which are passive investment income, then there is
imposed a tax on the income of such corporation for such taxable year. Such tax shall
be computed by multiplying the excess net passive income by the highest rate of tax
specified in § 11(b).
PLR-100266-21 4

Section 1375(b)(1)(A) provides that for purposes of § 1375, except as provided in §
1375(b)(1)(B), the term “excess net passive income” means an amount which bears the
same ratio to the net passive income for the taxable year as (i) the amount by which the
passive investment income for the taxable year exceeds 25 percent of the gross
receipts for the taxable year bears to (ii) the passive investment income for the taxable
year.

Section 1375(b)(1)(B) provides that the amount of the excess net passive income for
any taxable year shall not exceed the amount of the corporation’s taxable income for
such taxable year as determined under § 63(a): (i) without regard to the deductions
allowed by part VIII of subchapter B (other than the deduction allowed by § 248, relating
to organizational expenditures), and (ii) without regard to the deduction under § 172.

Section 1.1368-1(f)(3) provides that an S corporation may elect to distribute all or part of
its subchapter C earnings and profits through a deemed dividend. If an S corporation
makes the election provided in § 1.1368-1(f)(3), the S corporation will be considered to
have made the election provided in § 1.1368-1(f)(2) (relating to the election to distribute
earnings and profits first).

Section 1.1368-1(f)(5)(iii) provides that a corporation makes an election for a taxable
year under § 1.1368-1(f) by attaching a statement to a timely filed (including extensions)
original or amended return required to be filed under § 6037 for that taxable year. In the
statement, the corporation must identify the election it is making under § 1.1368-1(f) and
must state that each shareholder consents to the election. The statement described in §
1.1368-1(f)(5)(iii) shall be verified by signing the return. A statement of election to make
a deemed dividend under § 1.1368-1(f) must include the amount of the deemed
dividend that is distributed to each shareholder.

CONCLUSION

Based solely on the facts submitted and the representations made, we conclude that
X’s S corporation election terminated on Date 6 under § 1362(d)(3)(A) because X had
subchapter C earnings and profits at the close of each of three consecutive taxable
years ending on Date 5, and had gross receipts for each of those taxable years more
than 25 percent of which were passive investment income. We further conclude that the
termination of X’s S corporation election was an inadvertent termination within the
meaning of § 1362(f).

Pursuant to the provisions of § 1362(f), X will be treated as continuing to be an S
corporation beginning on Date 6, and thereafter, provided that Company’s S corporation
election was valid and has not otherwise terminated under § 1362(d), and provided that
the following condition is met: a payment of $b and a copy of this letter must be sent to
the following address: Internal Revenue Service, Kansas City Submission Processing
PLR-100266-21 5

Campus, 333 W. Pershing Road, Kansas City, MO 64108, Stop 7777, Attn: Manual
Deposit.

X must send this payment no later than 45 days from the date of this letter. If this
condition is not met, then this ruling is null and void. Furthermore, if this condition is not
met, X must notify the Kansas City Submission Processing Campus that its S
corporation election has terminated.

Except as expressly provided herein, we express or imply no opinion concerning the tax
consequences of any aspect of any transaction or item discussed or referenced in this
letter. In particular, 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) provides that
it may not be used or cited as precedent.

In accordance with a power of attorney on file with this office, we are sending a copy of
this letter to your authorized representative.

                                    Sincerely,

                                    /s/

                                    Laura C. Fields
                                    Branch Chief, Branch 1
                                    (Passthroughs & Special Industries)

Enclosures: Copy of this letter

Copy of this letter for § 6110 purposes

cc: