S corporation status preserved after a trust shareholder missed its ESBT election

Plain-English summary

An S corporation's tax status accidentally lapsed and the IRS restored it. An
S corporation can only have certain kinds of shareholders. A trust may hold
S corporation stock if it elects to be an Electing Small Business Trust
(ESBT), but the trustee must make that election within a short window. Here a
trust acquired shares in the company, and the trustee never made the ESBT
election, so the company automatically stopped qualifying as an S corporation
on the day the trust bought in. The company said the trust otherwise met all
ESBT requirements, the lapse was not motivated by tax avoidance, and everyone
had continued to file tax returns as if the S election were still in effect.
Under IRC Section 1362(f), the IRS can forgive an inadvertent termination and
treat the company as having remained an S corporation, provided the problem
is fixed and the shareholders agree to any needed adjustments. The IRS found
the termination inadvertent and ruled that the company continues to be
treated as an S corporation without interruption. The stock was later moved
to a permissible shareholder.

Ruling snapshot

• Question: Was the termination of the company's S election, caused by a trust shareholder's missed ESBT election, inadvertent under IRC § 1362(f) so that S status can be restored?
• Outcome: Approved (termination ruled inadvertent; company treated as continuing to be an S corporation from the termination date)
• Key authorities: IRC § 1362(f); IRC § 1362(d)(2); IRC § 1361(e) (ESBT) and § 1361(e)(3); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 202307004
Release Date: 2/17/2023
Index Number: 1362.00-00, 1362.04-00

Third Party Communication: None
Date of Communication: Not Applicable

Person To Contact: [redacted], ID No. [redacted]
Telephone Number: [redacted]

Refer Reply To: CC:PSI:03
PLR-111027-22

Date: November 18, 2022

Legend

X = [redacted]
State = [redacted]
Date 1 = [redacted]
Date 2 = [redacted]
Date 3 = [redacted]
Date 4 = [redacted]
Trust = [redacted]

Dear [redacted]:

This letter responds to a letter dated June 6, 2022, and subsequent correspondence submitted on behalf of X by its authorized representatives, requesting relief under § 1362(f) of the Internal Revenue Code (Code).

Facts

According to the information submitted and representations made, X was incorporated on Date 1, under the laws of State. Effective Date 2, X elected to be taxed as an S corporation.

On Date 3, Trust acquired shares in X. However, a timely election to treat Trust as an Electing Small Business Trust (ESBT) was not made, causing X's S corporation election to terminate effective Date 3. Trust continued to hold the X shares through Date 4, when the shares were transferred to a permissible shareholder. X represents that Trust has at all times met the requirements of an ESBT within the meaning of § 1361(e), except that the trustee of Trust did not make a timely ESBT election under § 1361(e)(3).

X represents that the circumstances resulting in the termination of its S corporation election were not motivated by tax avoidance or retroactive tax planning. Further, X represents that it and its shareholders have filed tax returns consistent with the treatment of X as an S corporation and Trust as an ESBT. Finally, 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 § 1362(a) is in effect for the year.

Section 1361(b)(1) provides that the term "small business corporation" means 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)(v) provides that for purposes of § 1361(b)(1)(B), an ESBT is a permissible shareholder.

Section 1361(e) 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 paragraph (2), (3), (4), or (5) of § 170(c), 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 all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

Section 1.1361-1(m)(2)(i) provides that the trustee of an ESBT must make the ESBT election by signing and filing, with the service center where the S corporation files its income tax return, a statement that meets the requirements of § 1.1361-1(m)(2)(ii).

Section 1.1361-1(m)(2)(iii) provides that the trustee of an ESBT must file the ESBT election within the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a qualified subchapter S trust election (within the 16-day-and-2-month period beginning on the day that the stock is transferred to the trust).

Section 1362(a) provides that a small business corporation may elect to be an S corporation.

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 terminated under § 1362(d)(2); (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 facts submitted and the representations made, we conclude that X's S corporation election terminated on Date 3 when Trust became an ineligible shareholder. We also conclude that the termination was 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 3 and thereafter, provided that X's S corporation election was valid and was not otherwise terminated under § 1362(d).

Except as specifically set forth 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 and the regulations thereunder. Specifically, we express or imply no opinion regarding X's eligibility to be an S corporation or Trust's eligibility to be an ESBT.

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 that requested it. Section 6110(k)(3) of the Code provides that 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 X's authorized representatives.

Sincerely,

Associate Chief Counsel
(Passthroughs & Special Industries)

By: /s/ Margaret Burow
Margaret Burow
Senior Counsel, Branch 3
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosure
Copy for § 6110 purposes

cc: [redacted]