S corporation status saved after an invalid election by an ineligible shareholder and a later missed trust election

Plain-English summary

An S corporation is a small business that passes its income through to shareholders instead of paying corporate tax, but only certain owners are allowed to hold the stock. This company had two problems. When it first elected S status, its only shareholder was an ineligible one and no eligible shareholder consented, so the election was never valid. Later, a trust bought shares but never filed the election to be treated as an Electing Small Business Trust (ESBT), which would have terminated S status had the original election been valid. The company represented that both slip-ups were inadvertent, not tax-motivated, and that it and its shareholders had filed all along as if it were a valid S corporation. Under Section 1362(f), the IRS can forgive inadvertent invalid elections and terminations, and it did so here. The company keeps S corporation treatment back to its original effective date, provided it files a corrected Form 2553 within 120 days.

Ruling snapshot

• Question: Were the company's invalid S election and would-be termination inadvertent under § 1362(f), so S status can be preserved?
• Outcome: approved (inadvertent; S status continues, contingent on a corrected Form 2553 within 120 days)
• Key authorities: IRC §§ 1361(b), 1361(c)(2), 1361(e), 1362(a), 1362(d)(2), 1362(f); Treas. Reg. § 1.1361-1(m)

Full text (IRS public release)

 Internal Revenue Service                                      Department of the Treasury
                                                               Washington, DC 20224

 Number: 202308004                                             Third Party Communication: None
 Release Date: 2/24/2023                                       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:03
  ---------------------------                                  PLR-111031-22
                                                               Date:
                                                               November 18, 2022




Legend

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

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

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

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

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

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

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

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

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


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

      This letter responds to a letter dated June 6, 2022, subsequent correspondence
submitted on behalf of X by its authorized representatives, requesting relief under
§ 1362(f) of the Internal Revenue Code (Code).
PLR-111031-22                                2


                                          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. However, X's election was not effective as X was owned by A, an
ineligible shareholder at the time of the election and because no eligible shareholder
consented to X's S corporation election. A continued to hold the X shares until Date 3,
when the shares were transferred to a permissible shareholder.

       On Date 4, Trust acquired shares in X. However, a timely election to treat Trust
as an Electing Small Business Trust (ESBT) was not made, which if not for X's
ineffective election, would have caused X's S corporation election to terminate effective
Date 4. Trust continued to hold the X shares until Date 5, 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 its invalid S corporation election
were not motivated by tax avoidance or retroactive tax planning. X additionally
represents that, if its S corporation election were effective, the circumstances that would
have resulted 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
PLR-111031-22                                 3

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 was not effective for the taxable year for which made by reason of a
failure to meet the requirements of § 1361(b) or to obtain shareholder consents, or
terminated under § 1362(d)(2); (2) the Secretary determines that the circumstances
resulting in such ineffectiveness or termination were inadvertent; (3) no later than a
reasonable period of time after discovery of the circumstances resulting in such
effectiveness of termination, steps were taken so that the corporation for which the
election was made or the termination occurred is a small business corporation or to
acquire the required shareholder consents; and (4) the corporation for which the
election was made or 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 ineffectiveness
or termination, such corporation shall be treated as an S corporation during the period
specified by the Secretary.
PLR-111031-22                                4


                                       Conclusion

        Based solely on the facts submitted and representations made, we conclude that
X's S corporation election was ineffective on Date 2 because an ineligible S corporation
shareholder owned shares of X stock on Date 2. In addition, we conclude that had X's
S corporation election been effective, it would have terminated on Date 4 when shares
of X's stock were transferred to Trust, an ineligible S corporation shareholder. We
conclude, however, that the ineffectiveness and termination described in this paragraph
were inadvertent within the meaning of § 1362(f). Therefore, X will be treated as an S
corporation effective Date 2 and thereafter, provided that its S corporation election was
otherwise valid and has not terminated under § 1362(d) other than as discussed in this
letter.

       This ruling is contingent on X filing a corrected Form 2553, Election by a Small
Business Corporation, with the appropriate service center, within 120 days from the
date of this letter, effective Date 2. A copy of this letter should be attached to the
election.

       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.
PLR-111031-22                                 5

        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)


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



Enclosure
      Copy for § 6110 purposes



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