S corporation's inadvertent termination forgiven under section 1362(f) after ineligible LLC shareholders bought in

Plain-English summary

A company that had elected to be taxed as an S corporation accidentally lost that status when three limited liability companies (one taxed as a partnership, two owned by corporations) bought shares. An S corporation can only have eligible shareholders, generally individuals, certain trusts, and estates, so these LLCs were ineligible owners and their purchase automatically terminated the S election. After discovering the problem, the company and its owners fixed the ownership so that all shares were held by eligible shareholders. Under section 1362(f), the IRS can forgive an inadvertent termination if the lapse was not tax-motivated, the company promptly corrected it, and everyone agrees to make any adjustments the IRS requires. The IRS found those conditions satisfied and ruled that the company will be treated as continuing to be an S corporation from the date of the termination onward, so it avoids a costly break in its passthrough tax status. The IRS expressed no opinion on whether the company was otherwise eligible to be an S corporation.

Ruling snapshot

• Question: Was the termination of the company's S corporation election (caused by ineligible LLC shareholders acquiring stock) inadvertent, so it can be disregarded under section 1362(f)?
• Outcome: Approved (inadvertent-termination relief granted; treated as an S corporation continuously)
• Key authorities: IRC § 1362(f); § 1362(d)(2); § 1361(b)(1)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 202319012                                              Third Party Communication: None
Release Date: 5/12/2023                                        Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
                                                               Person To Contact:
------------------------------------------------------         ------------------, ID No. -----------------
--------------------                                           Telephone Number:
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-----------------------------                                  Refer Reply To:
------------------------                                       CC:PSI:B03
------------------------------                                 PLR-117520-22
                                                               Date:
                                                               February 15, 2023


                  --------------------------------------------------------------
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                  Re:

Legend

X                 =        ------------------------------------------------------------------------------------------
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A                 =        -------------------------
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B                 =        --------------------------
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C                 =        ------------------------------------------
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State             =        ------------

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

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


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

        This letter responds to a letter dated September 9, 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 formed
as a limited liability company under the laws of State on Date 1 and elected to be taxed
as an S corporation effective Date 1.

      On Date 2, A, B, and C, all limited liability companies, acquired shares in X. A
was a partnership for federal tax purposes, and B and C were each wholly owned by a
corporation. As such, A, B, and C were ineligible S corporation shareholders. After
discovering the termination of X’s S corporation election, X and its shareholders took
remedial action to ensure X’s shares were all owned eligible S corporation shareholders.

       X represents that the circumstances resulting in the termination of its S
corporation election were not motivated by tax avoidance or retroactive tax planning. X
also represents that it and its shareholders intended for X to be an S corporation
beginning on Date 1.

       X further represents that all of its shareholders filed tax returns consistent with X
being an S corporation. 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 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 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); (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
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 the 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 A, B, and C
became ineligible shareholders. We further conclude that the termination was
inadvertent within the meaning 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 was
valid and not otherwise terminated under § 1362(d).

       Except as specifically ruled above, we express or imply no opinion as to the
federal income 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.

      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 requesting it. Section 6110(k)(3) of the
Code provides that it 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)


                                                             /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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