IRS forgives an S corporation's accidental termination after shares went to an ineligible shareholder

Plain-English summary

An S corporation gets pass-through tax treatment only if it stays within strict eligibility limits, including a rule that every shareholder must be an eligible type (generally an individual, an estate, or certain trusts). Here the corporation's owners issued shares to Y, a shareholder that turned out to be ineligible, which automatically terminated the company's S election on the date of that transfer, though the owners did not know Y was ineligible at the time. Once the company's lawyer flagged the problem, Y distributed its shares back to the eligible shareholders, fixing the eligibility defect. The company asked the IRS for relief under IRC § 1362(f), which lets the IRS forgive an inadvertent S-election termination if the lapse was not tax-motivated, the company fixed it within a reasonable time, and the shareholders agree to any corrective adjustments. The IRS agreed the termination was inadvertent and ruled that the company will be treated as an S corporation continuously, as if the termination never happened, provided its original election was valid. The ruling is limited to inadvertent-termination relief and expresses no view on whether the company otherwise qualifies as an S corporation. The lesson: an accidental transfer of S corporation stock to an ineligible holder is usually fixable through § 1362(f) relief once the shares are moved back to eligible owners.

Ruling snapshot

• Question: Was the termination of the corporation's S election, caused by issuing stock to an ineligible shareholder, inadvertent under IRC § 1362(f) so that S status can be preserved?
• Outcome: Approved (inadvertent termination; treated as an S corporation continuously)
• Key authorities: IRC § 1362(f); IRC § 1361(b)(1); IRC § 1362(a), (d)(2)

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 202321002                                            Third Party Communication: None
Release Date: 5/26/2023                                      Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.04-00
                                                             Person To Contact:
----------------------------------------------               -----------------------, ID No. -------------------
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------------------------------------------                   Telephone Number:
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--------------------------------                             Refer Reply To:
                                                             CC:PSI:01
                                                             PLR-116838-22
                                                             Date:
                                                             February 27, 2023

                                                   LEGEND

 X             = -----------------------------------------------------------------------------------------------
                 --------------------------
 A             = -----------------------------------------------------------------------------------------------
                 --------------------------
 B             = -----------------------------------------------------------------------------------------------
                 --------------------------
 Y             = -----------------------------------------------------------------------------------------------
                 --------------------------
 State         = --------
 Date 1        = ----------------------
 Date 2        = -------------------------
 Date 3        = ----------------
 Date 4        = -------------
 Date 5        = -------------------------

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

This responds to a letter dated August 31, 2022, submitted on behalf of X by X's
authorized representative, requesting relief under section 1362(f) of the Internal
Revenue Code (the Code).

                                                     FACTS

The information submitted states that X was organized under the laws of State on
Date 1 and elected to be treated as an S corporation, effective Date 2. On Date 3, A
and B issued shares of X to Y, an ineligible shareholder, thereby terminating X's S
election. A, B, and X were unaware that Y was an ineligible shareholder. On Date 4,
X's counsel informed A, B, and X that Y was an ineligible shareholder of X. On Date 5,
Y distributed its shares in X to A, B, and the remainder of the shareholders, all of which
are represented by X to be eligible S corporation shareholders.

X represents that it has filed tax returns consistent with being an S corporation since
Date 1. The circumstances resulting in the termination of X's S corporation
election were inadvertent and were not motivated by tax avoidance or retroactive tax
planning. X and its shareholders have agreed to make such adjustments (consistent
with the treatment of X as an S corporation) as may be required by the Secretary.

                                  LAW AND ANALYSIS

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 1361(a)(1) defines an "S corporation" as a small business corporation for which
an election under § 1362(a) is in effect for the taxable year.

Section 1361(b)(1) provides that a "small business corporation" means a domestic
corporation that is not an ineligible corporation and that 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(d)(2)(A) provides that 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 a
corporation is an S corporation) such corporation ceases to be a small business
corporation. Section 1362(d)(2)(B) provides that the termination shall be effective on
and after the date of cessation.

Section 1362(f) provides, in pertinent part, that if (1) an election under § 1362(a) by any
corporation was not effective for the taxable year for which made (determined without
regard to § 1362(b)(2), by reason of a failure to meet the requirements of section
1361(b), or terminated under § 1362(d)(2) or (3), (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 event resulting in the
ineffectiveness or termination, steps were taken (A) so that the corporation for which
the election was made or the termination occurred 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 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 such ineffectiveness or termination, the 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 was terminated on Date 3, under § 1362(d)(2), because
of the transfer of shares of X to Y, an ineligible shareholder. We conclude, however, that
the termination described in this paragraph was inadvertent within the meaning of §
1362(f). Accordingly, pursuant to the provisions of § 1362(f), X will be treated as an S
corporation from Date 2 and thereafter, provided X's S corporation election was valid
and was not otherwise terminated under § 1362(d).

Except for the specific ruling 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. In particular, we express or imply no opinion regarding X's eligibility to be an S
corporation.

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 the
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.

In accordance with a power of attorney on file with this office, we are sending a copy of
this letter ruling to your authorized representative.

                                      Sincerely,



                                      Laura C. Fields
                                      Laura C. Fields
                                      Branch Chief, Branch 1
                                      Office of the Associate Chief Counsel
                                      (Passthroughs & Special Industries)



Encl:
        Copy for § 6110 purposes


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