An S corporation's accidentally terminated election is restored after three shareholder trusts missed their ESBT elections

Plain-English summary

An S corporation can only have certain types of shareholders. A trust generally must file an "electing small business trust" (ESBT) election to qualify as an eligible shareholder. Here, stock of the S corporation was transferred to three trusts that were qualified to be ESBTs, but none of them filed the required ESBT election. That made them ineligible shareholders and automatically terminated the company's S corporation status on the transfer date. The company represented the failure was inadvertent, with no tax-avoidance motive, and asked for relief under section 1362(f). The IRS agreed the termination was inadvertent and ruled the company will be treated as having remained an S corporation, provided the trustees file the missing ESBT elections within 120 days, all affected parties file consistent returns, and a specified payment is made. This spares the company and its owners from an unintended switch to C corporation taxation over a paperwork slip.

Ruling snapshot

• Question: Was the termination of the company's S corporation election inadvertent under section 1362(f) when three shareholder trusts failed to file their ESBT elections, and should S status be restored?
• Outcome: Approved (termination ruled inadvertent; S corporation status continues, contingent on filing the ESBT elections, consistent returns, and a required payment).
• Key authorities: IRC § 1362(f); IRC §§ 1361(b), 1361(c)(2), 1361(e); Treas. Reg. §§ 1.1361-1(m), 1.1362-4.

Full text (IRS public release)

 Internal Revenue Service                               Department of the Treasury
                                                        Washington, DC 20224

 Number: 202208006                                      Third Party Communication: None
 Release Date: 2/25/2022                                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:B03
                                                        PLR-112378-21
                                                        Date:
                                                        November 01, 2021




Legend

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

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

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

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

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

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

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

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

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

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

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

Year 1     = -------
PLR-112378-21                                2

Year 2    = -------

n          = ---------------

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

This letter responds to a letter dated May 5, 2021, and subsequent correspondence,
written on behalf of X, requesting a ruling under § 1362(f) of the Internal Revenue Code.

                                          Facts

        X was incorporated under the laws of State and elected to be an S corporation
effective Date 1. X revoked its S corporation election effective Date 2. X reelected to
be an S corporation effective Date 3.

        On Date 4, Trust 1, Trust 2, and Trust 3 were created, and shares of X’s stock
were transferred to Trust 1, Trust 2, and Trust 3 on Date 5. X represents that Trust 1,
Trust 2, and Trust 3 were qualified to be Electing Small Business Trusts (ESBTs), within
the meaning of § 1361(e), however, no election was made under § 1361(e)(3) to treat
Trust 1, Trust 2, or Trust 3 as ESBTs. Consequently, Trust 1, Trust 2, and Trust 3 were
ineligible shareholders, and, as a result, X’s S corporation election terminated on Date
5.

       X represents that there was no intent to terminate X’s S corporation election and
that the failure to timely file the ESBTs elections for Trust 1, Trust 2, and Trust 3 were
inadvertent and not motivated by tax avoidance or retroactive tax planning. X and X’s
shareholders 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 the period specified by
§ 1362(f).

                                    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 shareholder 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 1361(c)(2)(A)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT
is a permissible shareholder.
PLR-112378-21                                3


       Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), the
term “electing small business trust” means any trust if (i) such trust does not have as a
beneficiary any person other than (I) an individual, (II) an estate, (III) an organization
described in § 170(c)(2)-(5), or (IV) an organization described in § 170(c)(1) which holds
a contingent interest in such trust and is not a potential current beneficiary, (ii) no
interest in such trust was acquired by purchase, and (iii) an election under § 1361(e)
applies to such trust.

       Section 1361(e)(3) provides that an election under § 1361(e) shall be made by
the trustee. Any such election shall apply to the taxable year of the trust for which made
and subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

       Section 1.1361-1(m)(2)(i) of the Income Tax Regulations provides that an
electing small business trust (ESBT) means any trust if it meets the following
requirements: the trust does not have as a beneficiary any person other than an
individual, an estate, an organization described in § 170(c)(2) through (5), or an
organization described in § 170(c)(1) that holds a contingent interest in such trust and is
not a potential current beneficiary; no interest in the trust has been acquired by
purchase; and the trustee of the trust makes a timely ESBT election for the trust.

       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 relevant part, that if (1) an election under § 1362(a)
by any corporation was terminated under § 1362(d)(2) or (3); (2) the Secretary
determines that the circumstances resulting in such 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 of the corporation at any
time during the period specified pursuant to § 1362(f), agrees to make the adjustments
(consistent with the treatment of the corporation as an S corporation) as may be
required by the Secretary with respect to this 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.

      Section 1.1362-4(d) of the Income Tax Regulations 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.
PLR-112378-21                                   4


                                          Conclusion

        Based solely on the facts submitted and representations made, we conclude that
X’s S corporation election was terminated on Date 5 when stock in X was transferred to
Trust 1, Trust 2, and Trust 3 because Trust 1, Trust 2, and Trust 3 failed to timely file
ESBT elections under § 1361(e)(3). We further conclude that the termination was
inadvertent within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), X
will be treated as continuing to be an S corporation on and after Date 5, unless X’s S
corporation election is otherwise terminated under § 1362(d). The trustee of Trust 1,
Trust 2, and Trust 3 must file an ESBT election effective Date 5 with the appropriate
service center within 120 days of the date of this letter.

        This ruling is contingent upon X and each of its shareholders, including the trusts
and their beneficiaries, filing any necessary original or amended returns consistent with
the relief granted in this letter within 120 days of the date of this letter. Specifically,
Trust 1, Trust 2, and Trust 3 must file original or amended returns and make
adjustments that are necessary to properly reflect the treatment of Trust 1, Trust 2, and
Trust 3 as ESBTs for Year 1 taxable year through and including Year 2 taxable year.

        Additionally, as an adjustment under § 1362(f), a payment of $n and a copy of
this letter ruling must be sent to the following address:

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

        This letter must be sent no later than Date 6.

       A copy of this letter must be attached to any ESBT elections and income tax
returns to which it is relevant. Alternatively, taxpayers filing their returns electronically
may satisfy this requirement by attaching a statement to their return that provides the
date and control number of the letter ruling.

        If all of the above conditions are not met, then this ruling is null and void.
Furthermore, if these conditions are not met, X must notify the Ogden Service Center
that its S corporation election has terminated.

         Except for the specific ruling above, no opinion is expressed or implied
concerning the federal tax consequences of the facts of this case under any other
provision of the Code. Specifically, no opinion is expressed or implied regarding X’s
eligibility to be an S corporation or Trust 1, Trust 2, or Trust 3’s eligibility to be ESBTs.
PLR-112378-21                                  5

      The rulings contained in this letter are 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 request for rulings, it is subject to verification on
examination.

      This ruling is directed only to the taxpayer who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.

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


                                           Sincerely,


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


Enclosures (2):

       A copy of this letter
       A copy for § 6110 purposes



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