S corporation status restored after three trusts flunked the QSST rules, ruled an inadvertent termination

Plain-English summary

An S corporation had its shares transferred to three trusts, and each trust's beneficiary elected to treat the trust as a qualified subchapter S trust (QSST), a permitted S corporation shareholder. But the trusts' own terms did not actually meet the QSST requirements, so the trusts were ineligible shareholders and the company's S election terminated on the transfer date. To fix it, the trustees converted the three trusts from QSSTs to electing small business trusts (ESBTs), another permitted shareholder type. The company sought relief under section 1362(f), representing that the termination was inadvertent and not tax-motivated and that everyone had reported income consistently. The IRS ruled the termination inadvertent and held the company continues to be treated as an S corporation from the termination date forward, provided the election was otherwise valid. It matters because it rescues S status when trusts intended to hold S corporation stock are drafted in a way that does not satisfy the strict QSST rules.

Ruling snapshot

• Question: Was the termination of the company's S election, caused by three trusts failing the QSST requirements, an inadvertent termination that can be excused?
• Outcome: Approved (S status restored from the termination date, subject to the standard conditions)
• Key authorities: IRC §§ 1361(b), 1361(d), 1362(a), 1362(d)(2), 1362(f); Treas. Reg. § 1.1361-1(j)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202147004 Third Party Communication: None
Release Date: 11/26/2021 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.02-00,
1362.02-02, 1362.04-00 Person To Contact:
--------------------, ID No. -----------------
---------------------------------------------- Telephone Number:
------------------------------ ---------------------
------------------------ Refer Reply To:
----------------------------- CC:PSI:03
---------------------------- PLR-104999-21
Date:
September 01, 2021

Legend

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

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

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

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

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

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

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

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

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

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

PLR-104999-21 2

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

    This letter responds to a letter dated March 1, 2021, submitted on behalf of X by

its authorized representative, requesting a ruling under § 1362(f) of the Internal
Revenue Code (Code).

                                      Facts

    The information submitted states that X elected to be treated as an S corporation

effective Date 1. On Date 2, shares of X were transferred to each of Trust 1, Trust 2,
and Trust 3 (collectively, the Trusts). Effective Date 2, A, B, and C (collectively, the
Beneficiaries) made elections to treat Trust 1, Trust 2, and Trust 3, respectively, as
qualified subchapter S trusts (QSSTs) within the meaning of 1361(d)(3). Despite the
stated intent in each of the trust instruments for the Trusts to be QSSTs, the Trusts by
their terms did not satisfy the qualifications under § 1361(d)(3). Thus, Trust 1, Trust 2,
and Trust 3 were ineligible shareholders of X, causing X's S corporation election to
terminate, effective Date 2.

   X states that, effective Date 3, the trustees of Trust 1, Trust 2, and Trust 3,

respectively, each requested under § 1.1361-1(j)(12) to convert Trust 1, Trust 2, and
Trust 3 from QSSTs to electing small business trust (ESBT) under § 1361(e).

   X represents that since Date 2, it has filed federal tax returns consistent with

being an S corporation. X represents the termination of its S corporation election was
inadvertent and was not motivated by a tax avoidance motive or retroactive tax
planning. X further represents that A, B, and C reported their allocable share of Trust 1,
Trust 2, and Trust 3’s income, respectively, on all affected returns consistent with the
treatment of the Trusts as QSSTs from Date 2 to Date 3. X represents that X and its
shareholders agree to make any adjustments consistent with the treatment of X as an S
corporation as may be required by the Secretary.

                                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 section
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 section 1361(c)(2), or an organization described in section 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.
PLR-104999-21 3

   Section 1361(d)(1) provides that a QSST whose beneficiary makes an election

under § 1362(d)(2) will be treated as a trust described in § 1361(c)(2)(A)(i), and the
QSST's beneficiary will be treated as the owner (for purposes of section 678(a)) of that
portion of the QSST's S corporation stock to which the election under § 1361(d)(2)
applies.

    Section 1361(d)(3) defines a QSST as a trust (A) the terms of which require that

(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust; (ii) any corpus distributed during the life of the current
beneficiary may be distributed only to such beneficiary; (iii) the income interest of the
current income beneficiary in the trust shall terminate on the earlier of such beneficiary's
death or the termination of the trust; and (iv) upon termination of the trust during the life
of the current income beneficiary, the trust shall distribute all of its assets to that
beneficiary; and (B) all of the income (within the meaning of section 643(b)) of which is
distributed (or required to be distributed) currently to one individual who is a citizen or
resident of the United States.

   Section 1.1361-1(j)(6)(ii) of the Income Taxation Regulations provides that the

current income beneficiary of the trust must make the election by signing and filing with
the service center with which the corporation files its income tax return the applicable
form or a statement including the information listed in § 1.1361-1(j)(6)(ii).

  Section 1362(d)(2)(A) provides that an election under § 1362(a) shall be

terminated whenever the corporation ceases to be a small business corporation.

   Section 1362(f) provides, in relevant part, that if (1) an election under section

1362(a) by any corporation was terminated under section 1362(d)(2); (2) the Secretary
determines that the circumstances resulting in termination were inadvertent; (3) no later
than a reasonable period of time after discovery of the circumstances resulting in such
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 specified pursuant to section 1362(f), agrees to make the adjustments
(consistent with the treatment of such 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.

                                    Conclusion

   Based solely on the facts submitted and the representations, we conclude that

X's S corporation election terminated within the meaning of § 1362(f) on Date 2 when
stock was transferred to Trust 1, Trust 2, and Trust 3, ineligible shareholders. We
further conclude that the termination of X's S corporation election on Date 2 was
inadvertent within the meaning of section 1362(f). Pursuant to the provisions of section
PLR-104999-21 4

1362(f), X will be treated as continuing to be an S corporation from Date 2 and
thereafter, provided that X's S corporation election is valid and not otherwise terminated
under section 1362(d) for reasons not stated in this letter.

     Except as specifically ruled upon above, we express or imply no opinion

concerning the federal tax consequences of the facts of this case under any other
provision of the Code. Specifically, we express or imply no opinion regarding X's
eligibility to be an S corporation or Trust 1, Trust 2, and Trust 3’s eligibility to qualify as
an ESBT.

  This ruling is directed only to the taxpayer who requested it. According to section

6110(k)(3), this ruling may not be used or cited as precedent.

    Pursuant to the power of attorney on file with this office, we are sending a copy of

this letter to your authorized representative.

                                     Sincerely,




                                     Adrienne M. Mikolashek
                                     Chief, Branch 3
                                     Office of the Associate Chief Counsel
                                     (Passthroughs & Special Industries)

Enclosure:
Copy for 6110 purposes

cc: