S corporation election restored after two trusts missed their ESBT elections

Plain-English summary

An S corporation asked the IRS to forgive an accidental loss of its S status. Two of its shareholders were trusts. One trust had been a qualified subchapter S trust (QSST); after its income beneficiary died, it stayed an eligible shareholder for only two more years and then needed to become an electing small business trust (ESBT) to keep holding the stock. The second trust was a grantor trust that likewise had a two-year grace period after its owner's death. Neither trust filed the required ESBT election, so the company's S election terminated. The IRS concluded the termination was inadvertent under § 1362(f) and agreed to treat the company as an S corporation without interruption, provided both trustees now file late ESBT elections and the company makes a required payment. This matters because losing S status can trigger corporate-level tax; § 1362(f) relief lets a company fix an honest paperwork lapse.

Ruling snapshot

• Question: Was the termination of the company's S corporation election, caused by two trust shareholders failing to file ESBT elections, inadvertent under § 1362(f)?
• Outcome: approved (relief granted, subject to conditions)
• Key authorities: IRC § 1362(f); IRC § 1361(c)(2), (e); Treas. Reg. § 1.1361-1(h), (j)(7)(ii), (m)

Full text (IRS public release)

 Internal Revenue Service                                         Department of the Treasury
                                                                  Washington, DC 20224

 Number: 202310003                                                Third Party Communication: None
 Release Date: 3/10/2023                                          Date of Communication: Not Applicable
 Index Number: 1362.04-00
                                                                  Person To Contact:
 -------------------                                              --------------------, ID No. -----------------
 ------------------------------------------------------------     Telephone Number:
 --------------------------                                       --------------------
 ---------------------------                                      Refer Reply To:
 ---------------------------                                      CC:PSI:B03
                                                                  PLR-110742-22
                                                                  Date:
                                                                  November 28, 2022




LEGEND:

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

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

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

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

B                         =        ----------------------------

C                         =        -------------------------

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

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

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

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

Date 4                    =        ------------------------
PLR-110742-22                                       2


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

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

Date 7                 =    ---------------------

Date 8                 =    -------------------------

Date 9                 =    -------------------------

Date 10                =    --------------------------

N                      =    ---------------

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

       This letter responds to a letter dated May 23, 2022, and subsequent
correspondence, submitted on behalf of X by its authorized representatives requesting a
ruling under § 1362(f) of the Internal Revenue Code (Code).

                                              FACTS

       The information submitted states that X was incorporated on Date 1 under the
laws of State. X elected to be an S corporation effective Date 2. A and B each owned
X stock.

       On Date 3, A died, and his executor created Trust 1 on Date 4, for the benefit of
C during her life and funded the trust, in part, with A’s X stock. C made a qualified
subchapter S trust (QSST) election for Trust 1, effective Date 4.

       On Date 5, C died. Trust 1 continued as a trust for the benefit of A’s children.
Under § 1.1361-1(j)(7)(ii), Trust 1 remained an eligible shareholder through Date 6, two
years after Trust 1 ceased to be a QSST on Date 5. X’s S corporation election
terminated on Date 6, because no electing small business trust (ESBT) election was
made for Trust 1. X represents that, Trust 1 was qualified to elect to be an ESBT”)
under § 1361(e) (1), however no ESBT election was filed. On Date 10, the trustees of
Trust 1 terminated the trust, and distributed the X voting stock in Trust 1 to A’s children.

       B transferred her shares in X to Trust 2, a revocable trust, prior to her death on
Date 7. X represents that Trust 2 was a trust described in § 1361(c)(2)(A)(i) of which B
was the deemed owner. On Date 8, B died, causing Trust 2 to cease being a grantor
trust. Under § 1361(c)(2)(A)(ii), Trust 2 remained an eligible shareholder of X until Date
9, two years after B’s death. Accordingly, Trust 2 ceased to be an eligible shareholder
of X on Date 9. X’s S corporation election, had it not otherwise terminated on Date 6,
PLR-110742-22                                 3

would have terminated on Date 9. X represents that Trust 2 was qualified to elect to be
an ESBT under § 1361(e)(1), but no ESBT election was filed.

        X represents that there was no tax avoidance or retroactive tax planning involved
in the failure of Trust 1 and Trust 2 to file ESBT elections and the resulting termination
of X’s S corporation election. X and its shareholders agree to make any adjustments
required as a condition of obtaining relief under the inadvertent termination rule as
provided under § 1362(f) of the Code that may be required by the Secretary.

                                           LAW

        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)(B) defines a “small business corporation”, in part, as a
domestic corporation which is not an ineligible corporation and which does not 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.

       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) as owned by
an individual who is a citizen or resident of the United States is a permitted S
corporation shareholder.

       Section 1361(c)(2)(A)(ii) provides that for purposes of § 1361(b)(1)(B), a trust
which was described in § 1361(c)(2)(A)(i) immediately before the death of the deemed
owner and which continues in existence after such death, is a permitted S corporation
shareholder, but only for the 2-year period beginning on the day of the deemed owner’s
death.

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

         Section 1361(e)(1)(A) provides that, for purposes of § 1361, 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
PLR-110742-22                                4

Secretary.

       Section 1.1361-1(h)(1)(ii) of the Income Tax Regulations provides that, on death
of the deemed owner, a trust that was a qualified subpart E trust immediately before the
death of the deemed owner continues in existence after the death of the deemed owner,
but only for the 2-year period beginning on the day of the deemed owner's death.

        Section 1.1361-1(j)(7)(ii) provides that if, upon the death of the QSST income
beneficiary, the trust continues in existence and continues to hold S corporation stock
but no longer satisfies the QSST requirements, is not a grantor trust or an ESBT, then,
solely for purposes of 1361(b)(1), as of the date of the income beneficiary’s death, the
estate of that income beneficiary is treated as the shareholder of the S corporation for 2
years or the transfer of the stock by the trust.

      Section 1.1361-1(m)(2)(i) provides, in part, 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 ESBT election must be filed within
the time requirements prescribed in § 1.1361-1(j)(6)(iii) for filing a QSST election.

      Section 1362(a) provides that, except as provided in § 1362(g), a small business
corporation may elect, in accordance with the provisions of § 1362, 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(d)(2)(B) provides that any termination under § 1362(d)(2)(A) is
effective on and after the date of cessation.

       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 the 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 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 such adjustments (consistent with the treatment of the corporation as an S
corporation) as may be required by the Secretary with respect to such period, then,
notwithstanding the circumstances resulting in the termination, the corporation will be
PLR-110742-22                                 5

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
X’s S corporation election terminated on Date 6, because no ESBT election was filed for
Trust 1. Further, if X’s S corporation election had not already terminated on Date 6, the
election terminated on Date 9, because Trust 2 remained an eligible shareholder until
Date 9, two years after B’s death and no ESBT election had been filed for Trust 2. We
further conclude that the termination of X’s S election on Date 6, was inadvertent within
the meaning of § 1362(f). Accordingly, X will be treated as an S corporation effective
Date 6, and thereafter, provided that X’s S corporation election was otherwise valid and
was not otherwise terminated under § 1362(d).

        This letter ruling, is subject to the following must be filed with the appropriate
service center within 120 days from the date of this letter (1) the trustee of Trust 1 must
file an ESBT effective Date 6, (2) the trustee of Trust 2 must file an election to treat
Trust 2 as an EBST effective Date 9. A copy of this letter must be attached to each
ESBT election.

        Furthermore, as an adjustment under § 1362(f)(4), a payment of $N and a copy of
this letter must be sent to the following address within 45 days from the date of this letter:
Internal Revenue Service, Kansas City Submission Processing Campus, 333 W.
Pershing Road, Kansas City, MO 64108, Stop 7777, Attn: Manual Deposit.

        If the above conditions are not met, then this ruling is null and void. Furthermore,
if these conditions are not met, X must notify the service center where X’s S corporation
election is filed that its S corporation election has terminated effective Date 6.

         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 corporation, or Trust 1 and Trust 2’s eligibility to be ESBTs.

       The ruling contained in this letter is based on 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)
provides that this ruling may not be used or cited as precedent.
PLR-110742-22                                 6


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


                                                  Sincerely,




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




Enclosure:
      Copy for § 6110 purposes


cc: