Late ESBT election did not end S corporation status

Plain-English summary

A grantor trust held stock in an S corporation and remained an eligible shareholder for two years after the grantor's death. When that period ended, the trust met the substantive requirements for an electing small business trust, but its trustee did not timely file the ESBT election. That failure made the trust an ineligible shareholder and terminated the corporation's S election. The corporation represented that the mistake was inadvertent, was not motivated by tax avoidance or retroactive planning, and that all returns had treated the S election as continuing. The IRS granted relief under section 1362(f), conditioned on filing the ESBT election and amended returns for all open years within 120 days.

Ruling snapshot

• Question: Could an S corporation retain its status after a trust shareholder failed to file a timely ESBT election when its post-death eligibility period expired?
• Outcome: approved
• Key authorities: IRC §§ 1361(c)(2), 1361(e), and 1362(f); Treas. Reg. § 1.1361-1(m)(2)

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 202352017                                            Third Party Communication: None
Release Date: 12/29/2023                                     Date of Communication: Not Applicable
Index Number: 1361.00-00, 1361.03-00,
              1361.03-01, 1361.03-03,                        Person To Contact:
              1362.02-00, 1362.04-00                         ------------------------, ID No. -----------------
                                                             Telephone Number:
---------------------------------------------------          --------------------
----------------------------------                           Refer Reply To:
----------------------------------------                     CC:PSI:B01
----------------------------------------------               PLR-112194-23
------------------------------                               Date:
------------------------------------                         October 03, 2023

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

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

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

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

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

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

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

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

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

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

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

This letter responds to a letter dated May 24, 2023, 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, and filed an election under § 1362(a) to elect to be treated as an S corporation
effective Date 2. Trust was formed on Date 3 and was treated (under subpart E of part I
of subchapter J of the Code) as a wholly-owned grantor trust as to A. A transferred all of
A’s shares in X to Trust on Date 4. Trust ceased to be a grantor trust upon A’s death on
Date 5. Trust continued to qualify as an eligible S corporation shareholder under §
1361(c)(2)(A)(ii) for the two-year period beginning on the day of A’s death and ending
Date 6.

X represents that beginning on Date 6, Trust met the requirements of an Electing Small
Business Trust (ESBT) within the meaning of § 1361(e)(1)(A). However, the trustee of
Trust failed to file a timely election under § 1361(e)(3) for Trust to be treated as an
ESBT, thus causing X’s S corporation election to terminate effective Date 6.

X represents that the circumstances resulting in the failure to file an ESBT election for
Trust were inadvertent and not motivated by tax avoidance or retroactive tax planning. X
further represents that it has filed income tax returns consistent with having a valid S
election in effect for all taxable years since its election to be an S corporation. X and its
shareholders agree to make any adjustments required by the Secretary as a condition
of obtaining relief under the inadvertent termination rule as provided under § 1362(f).

LAW AND ANALYSIS

Section 1361(a)(1) of the Code 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 such 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 one class of stock.

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 that was
described in § 1361(c)(2)(A)(i) immediately before the death of the deemed owner and
that continues in existence after such death is a permitted S corporation shareholder,
but only for the two-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 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 § 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)(1)(B) provides that the term “electing small business trust” shall not
include (i) any qualified subchapter S trust (as defined in § 1361(d)(3)) if an election
under § 1362(d)(2) applies to any corporation the stock of which is held by such trust,
(ii) any trust exempt from tax under subtitle A, and (iii) any charitable remainder annuity
trust or charitable remainder unitrust (as defined in § 664(d)).

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
Secretary.

Section 1.1361-1(m)(2)(i) of the Income Tax Regulations 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 (generally
within the 16-day-and-2-month period beginning on the day that the stock is transferred
to the trust).

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 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 § 1361(b) or
to obtain shareholder consents or was 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 ineffectiveness or 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.

CONCLUSION

Based solely on the facts submitted and representations made, we conclude that X's S
corporation election terminated on Date 6 due to the failure to file a timely ESBT
election for Trust, thereby making it an ineligible shareholder. We further conclude that
the termination of X's S corporation election was inadvertent within the meaning of §
1362(f). Accordingly, under the provisions of § 1362(f), X will be treated as continuing to
be an S corporation on Date 6 and thereafter, provided that X's S corporation election
was otherwise valid and was not otherwise terminated under § 1362(d).

This ruling in contingent upon the trustee of Trust filing an appropriately completed
ESBT election for Trust effective Date 6, and upon Trust and its beneficiaries filing
amended federal income tax returns for all open years consistent with the treatment of
Trust as an ESBT effective Date 6. The election must be made and the amended
returns must be timely filed with the appropriate service center within 120 days following
the date of this letter, and a copy of this letter should be attached to the returns. If these
conditions are not met, this ruling is null and void.

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’s eligibility to be an ESBT.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3),
this ruling may not be used or cited as precedent.

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.

Pursuant to the power of attorney on file with this office, we are sending a copy of this
letter to X's authorized representative.

                                                Sincerely,

                                                ______________________________
                                                Darshan Chulani
                                                Senior Counsel, Branch 1
                                                Office of the Associate Chief Counsel
                                                (Passthroughs & Special Industries)

Enclosure
     Copy for § 6110 purposes

cc: ---------------------------------------------------
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