S-corporation's inadvertent termination (shares held by non-qualifying trusts) is forgiven

Plain-English summary

An S corporation can only have certain kinds of shareholders. A trust generally qualifies only if it is a "grantor trust" treated as owned by an individual. Here two shareholders each set up a trust for their children and moved company shares into it, but those trusts did not actually qualify as grantor trusts. That defect terminated the company's S election, though everyone kept filing as if the company were still an S corporation. After discovering the problem, the shareholders amended the trusts so they now qualify. The IRS ruled the termination was inadvertent under § 1362(f), so the company will be treated as continuing to be an S corporation from the date of the botched transfers, and the two trusts are treated as qualifying grantor trusts for the affected years. This is a companion ruling to two others issued the same day on the same facts.

Ruling snapshot

• Question: Was the termination of the company's S election (when shares passed to trusts that were not qualifying grantor trusts) inadvertent under § 1362(f), so S status can be preserved?
• Outcome: approved (inadvertent termination; S status continues; trusts treated as qualifying shareholders)
• Key authorities: IRC § 1361(b)(1); IRC § 1361(c)(2)(A)(i); IRC § 1362(d)(2); IRC § 1362(f)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 202241004                                             Third Party Communication: None
Release Date: 10/14/2022                                      Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00,
              9100.00-00                                      Person To Contact:
                                                              ----------------------------, ID No. --------------
-------------------------------------                         -----------------
-----------------------------------------------------         Telephone Number:
-------------------------------------                         --------------------
-----------------------------                                 Refer Reply To:
---------------------------                                   CC:PSI:B01
                                                              PLR-124807-21

                                                              Date:


                                                              July 5, 2022


                                                    LEGEND

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

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

Year 1         =       -------

Year 2         =       -------

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

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

Y              =       ----------------------

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

Trust 2        =       -----------------------------------------------------------------------------------------
                       -----------------------------------------------------------------------------------------
                       ------------------
                       ----------------------
PLR-124807-21                                2

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

This responds to your letter dated November 29, 2021, and subsequent
correspondence, submitted on behalf of A requesting relief under § 1362(f) of the
Internal Revenue Code.

                                          FACTS

According to the information submitted, A was incorporated in State in Year 1 and made
an S election effective Year 1.

On Date 1, X, a shareholder of A, created Trust 1 for the benefit of his children and
transferred shares of A to Trust 1. Also on Date 1, Y, a shareholder of A, created Trust
2 for the benefit of his children and transferred shares of A to Trust 2.

For the taxable years from Year 1 to Year 2 Trust 1 was incorrectly treated as a grantor
trust with X as owner and, consequently, X reported the income of Trust 1 on his
personal tax returns for the relevant years. For the taxable years from Year 1 to Year 2,
Trust 2 was incorrectly treated as a grantor trust with Y as owner and, consequently, Y
reported the income of Trust 2 on his personal tax returns for the relevant years.

A recently discovered that Trust 1 and Trust 2 did not qualify as grantor trusts. Within a
reasonable time after the discovery of these mistakes, it is represented that X and Y
caused the amendment of Trust 1 and Trust 2 so that Trust 1 and Trust 2 now qualify as
grantor trusts.

It is represented that at all relevant times, A and its shareholders treated A as an S
corporation and filed all tax returns consistent with the treatment of A as an S
corporation.

A and its shareholders have agreed to make any adjustments consistent with the
treatment of A as an S corporation as may be required by the Secretary with respect to
the period specified by § 1362(f).
PLR-124807-21                                3

                                  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 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 of part I of subchapter J of chapter 1 of the Internal
Revenue Code) as owned by an individual who is a citizen or resident of the United
States may be a shareholder.

Section 1362(d)(2) provides that (A) an election under § 1362(a) shall be terminated
whenever (at any time on or after the first day of the first taxable year for which the
corporation is an S corporation) such corporation ceases to be a small business
corporation; and (B) any termination under § 1362(d)(2) shall be effective on and after
the date of cessation.

Section 1362(f) provides 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 the
termination, steps were taken so that the corporation is a small business corporation;
and (4) the corporation, and each person who was a shareholder of the corporation at
any time during the period specified under § 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 for that period, then, notwithstanding the circumstances
resulting in such termination, the corporation shall be treated as an S corporation during
the period specified by the Secretary.

                                     CONCLUSION

Based solely on the facts submitted and representations made, we conclude that A's S
election terminated on Date 1 when shares of A were transferred to Trust 1 and Trust 2.
We further conclude that the termination was inadvertent within the meaning of
§ 1362(f).
PLR-124807-21                                   4

Accordingly, under § 1362(f), A will be treated as continuing to be an S corporation from
Date 1, provided, that A's S election is valid and not otherwise terminated under
§ 1362(d).

Additionally, Trust 1 and Trust 2 will be treated as trusts described in § 1361(c)(2)(A)(i)
from Year 1 until Year 2.

Except as specifically ruled above, we express or imply no opinion concerning the
federal tax consequences of the transactions described above under any other
provision of the Code. Specifically, we express or imply no opinion regarding whether A
is otherwise eligible to be an S corporation. Additionally, no opinion is expressed on the
income tax consequences of Trust 1 and Trust 2 converting from non-grantor trusts to
grantor trusts.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides
that it may not be used or cited as precedent. In accordance with the power of attorney
on file with this office, a copy of this letter is being sent to A's authorized
representatives.


                                   Sincerely,


                                    _____________________
                                   Joy C. Spies
                                   Senior Technician Reviewer, Branch 1
                                   (Passthroughs & Special Industries)




Enclosure
      Copy for § 6110 purposes


cc: