Inadvertent-termination relief keeps S corporation status after a trust flaw and a missed ESBT election

Plain-English summary

An S corporation's tax status can end automatically if its stock ends up in the hands of an ineligible shareholder, such as the wrong kind of trust. Here shares were transferred to an irrevocable trust that the company believed qualified as an eligible grantor trust, but the trust's terms did not actually meet the requirements, so the S election terminated on the date of that transfer. Separately, after the grantor died the trust could have qualified as an Electing Small Business Trust (ESBT), but the trustee never filed the required ESBT election, which would have terminated the S election a second time. The company asked for relief under section 1362(f), which lets the IRS disregard an inadvertent termination if the corporation fixes the problem and everyone agrees to consistent tax treatment. The IRS ruled the terminations were inadvertent and treated the company as remaining an S corporation throughout, on the condition that the trustee file the ESBT election within 120 days.

Ruling snapshot

• Question: Were the terminations of the corporation's S election inadvertent, so that S status can be preserved under section 1362(f)?
• Outcome: approved
• Key authorities: IRC § 1362(f); IRC § 1361(c)(2)(A)(i), § 1361(e) (ESBT)

Full text (IRS public release)

 Internal Revenue Service                                    Department of the Treasury
                                                             Washington, DC 20224

 Number: 202229026                                           Third Party Communication: None
 Release Date: 7/22/2022                                     Date of Communication: Not Applicable
 Index Number: 1362.04-00
                                                             Person To Contact:
 -------------------------                                   --------------, ID No. -----------------
 -------------------------                                   Telephone Number:
 --------------------------                                  --------------------
 ---------------------------------                           Refer Reply To:
 ---------------------------                                 CC:PSI:B01
                                                             PLR-121709-21
                                                             Date:
                                                             April 18, 2022
Legend

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

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

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

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

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

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

 Trust          =       -----------
                        -------------


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

This letter responds to a letter dated October 13, 2021, and subsequent
correspondence, submitted on behalf of X by X’s authorized representatives, requesting
inadvertent termination relief under § 1362(f) of the Internal Revenue Code (Code).

                                                     Facts

According to the information submitted and representations within, X was incorporated
under the laws of State on Date 1. X filed a timely election under § 1362(a) of the Code
to be taxed as an S corporation effective Date 1.

On Date 2, A, an individual, transferred shares of X stock to Trust, an irrevocable trust.
X represents that X believed that Trust was a permissible S corporation shareholder
PLR-121709-21                             2

under § 1361(c)(2)(A)(i). Further, X represents that Trust and A filed tax returns as if
Trust was treated (under subpart E of Part I of subchapter J of chapter 1 of the Code)
as a grantor trust all of which was owned by A until Date 3 when A died. However, Trust
by its terms did not satisfy the qualifications under § 1361(c)(2)(A)(i). Consequently, X’s
S corporation election terminated on Date 2.

Following A’s death, X represents that Trust qualifies as an Electing Small Business
Trust (ESBT) under § 1361(e)(1)(A) effective Date 3. However, the trustee of Trust
failed to file an ESBT election under § 1361(e)(3) effective Date 3. Therefore, had X's S
corporation election not already terminated on Date 2, it would have terminated on Date
3.

X represents that the circumstances resulting in the termination of X’s S corporation
election were not motivated by tax avoidance or retroactive tax planning considerations.
Additionally, X represents that X and its shareholders have filed their federal income tax
returns consistent with having a valid S corporation election in effect for X. X and its
shareholders have agreed 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) of the Code 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 1
class of stock.

Section 1361(c)(2)(A)(i) provides that for purposes of § 1361(b)(1)(B), a trust all of
which is treated (under subpart E) as owned by an individual who is a citizen or resident
of the United States may be a shareholder of an S corporation.

Section 1361(c)(2)(A)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT may
be an S corporation shareholder

Section 1361(e)(1)(A) provides that an ESBT 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), (3), (4), or (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.
PLR-121709-21                             3


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
all subsequent taxable years of such trust unless revoked with the consent of the
Secretary.

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, in relevant part, that if (1) an election under § 1362(a) by any
corporation was terminated under § 1362(d)(2) or (3) or § 1361(b)(3)(C); (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 in such
corporation at any time during the period specified pursuant to § 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 termination, such corporation shall
be treated as an S corporation during the period specified by the Secretary.

                                        Conclusion

Based solely on the information submitted and the representations made, we conclude
that X’s S corporation election terminated on Date 2, when shares of X were transferred
to Trust. In addition, had X’s S corporation election had not already terminated on Date
2, it would have terminated on Date 3 when the trustee of Trust failed to make an
election under 1361(e)(3) to treat Trust as an ESBT effective Date 3. We further
conclude that circumstances resulting the termination of X’s S corporation were
inadvertent within the meaning of § 1362(f). Accordingly, pursuant to the provisions of
§ 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 otherwise effective and not
terminated under § 1362(d) for reasons not addressed in this letter.

Trust will be treated will be treated as a trust described in § 1361(c)(2)(A)(i) from Date 2
until Date 3. Further, Trust will be treated as a ESBT from Date 3 and thereafter,
provided that the trustee of Trust files an ESBT election effective Date 3 with the
appropriate service center within 120 days from the date of this letter. A copy of this
letter should be attached the ESBT election.

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
PLR-121709-21                             4

corporation.

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

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.

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


                                       Sincerely,



                                       _____________________________
                                       Jennifer Keeney
                                       Senior Counsel, Branch 1
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)




Enclosure

       Copy for § 6110 purposes




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