S corporation receives inadvertent termination relief after entity conversions

Plain-English summary

An S corporation converted to a state limited partnership while electing to remain classified as a corporation for federal tax purposes, a change that may have created a prohibited second class of stock. Its general partner was an LLC owned as community property by two spouses and initially treated as a disregarded entity. The LLC later filed a partnership return, which made it a partnership and therefore an ineligible S corporation shareholder. After the problem was discovered, the owners and their estates changed the ownership structure, converted the S corporation to an LLC classified as a corporation, and removed the partnership shareholder. The IRS found that both the possible stock-class termination and the ineligible-shareholder termination were inadvertent. It treated the company as continuously eligible for S corporation status, provided the original election was valid, no other termination occurred, and the company and shareholders make any required adjustments.

Ruling snapshot

• Question: May the company retain continuous S corporation status despite a possible second class of stock and a period with an ineligible partnership shareholder?
• Outcome: Approved, subject to continued eligibility and any required adjustments
• Key authorities: IRC §§ 1361, 1362(f); Treas. Reg. § 1.1361-1(l); Rev. Proc. 2002-69

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202442002 Third Party Communication: None
Release Date: 10/18/2024 Date of Communication: Not Applicable
Index Number: 1362.04-00
Person To Contact:
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---------------------------------------- Telephone Number:
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-------------------- Refer Reply To:
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PLR-101483-24
Date:
July 17, 2024

                                             LEGEND

X = -------------------------------------------------------------------------------------
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A = -------------------------------------------------------------------------------------
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B = -------------------------------------------------------------------------------------
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C = -------------------------------------------------------------------------------------
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Estate 1 = -------------------------------------------------------------------------------------
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Estate 2 = -------------------------------------------------------------------------------------
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State = --------

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

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

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

PLR-101483-24 2

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

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

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

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

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

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

This letter responds to a letter dated December 26, 2023, and supplemental information
submitted on behalf of X by X’s authorized representatives, requesting inadvertent
termination relief under § 1362(f) of the Internal Revenue Code (Code).

                                          FACTS

The information submitted represents that X was incorporated under the laws of State
on Date 1 and elected S corporation status effective Date 1.

On Date 2, X converted from a State corporation to a State limited partnership and filed
Form 8832, Entity Classification Election, to be classified as an association taxable as a
corporation effective Date 2. X represents that the conversion qualified as a
reorganization under § 368(a)(1)(F) and therefore X continued as an S corporation.
However, the conversion to a State limited partnership on Date 2 may have created a
second class of stock in violation of the one class of stock requirement under
§ 1361(b)(1)(D), thereby possibly causing X’s S corporation election to terminate.

After the conversion on Date 2, X’s limited partners were individual spouses A and B
and X’s general partner was C, a State limited liability company. C was wholly owned
by A and B as community property under the laws of State. X represents that A and B
treated C as a disregarded entity from Date 2 until Date 3. However, for the tax year
beginning Date 3, C filed Form 1065, U.S. Return of Partnership Income, inadvertently
converting C from a disregarded entity to a partnership for federal income tax purposes
effective Date 3. Therefore, C, as a partnership, became an ineligible shareholder of X
under § 1361(b)(1)(B) causing X’s S corporation election, if not otherwise terminated, to
terminate on Date 3.

On Date 4, A died and her interest in X and C passed to her estate, Estate 1. Thus, C
remained a partnership with Estate 1 and B as equal partners. On Date 5, B died and
his interest in X and C passed to his estate, Estate 2.

Upon discovering that it had an ineligible shareholder and that it may have had more
than two classes of stock, X took the following actions:

PLR-101483-24 3

On Date 6, Estate 2 acquired Estate 1’s interest in C causing C to become wholly
owned by Estate 2 and therefore a disregarded entity.

Effective Date 7, X converted from a limited partnership to a limited liability company
under the laws of State. X filed Form 8832, Entity Classification Election, to be treated
as an association taxable as a corporation effective Date 7. X represents that the
reorganization qualified as a reorganization under § 368(a)(1)(F) and that X intended at
all times for X to remain a valid S corporation.

On Date 8, C distributed its interest in X to Estate 2. Thus, Estate 1 and Estate 2
became the sole shareholders of X effective Date 8.

X represents that there was no tax avoidance or retroactive tax planning involved, and
the resulting termination of X’s S corporation election was inadvertent. X and its
shareholders agree to make any adjustments that the Secretary may require as a
condition of obtaining relief under the inadvertent termination rule as provided under
§ 1362(f) of the Code.

                              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) defines a “small business corporation” as 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 1.1361-1(l)(1) provides, in part, that a corporation is generally treated as having
only one class of stock if all outstanding shares of stock of the corporation confer
identical rights to distribution and liquidation proceeds.

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 paragraph (2) or (3) of § 1362(d), (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

PLR-101483-24 4

termination, steps were taken so that the corporation is once more 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 any adjustments (consistent with the treatment of the corporation as an
S corporation) as may be required by the Secretary with respect to the period. Then,
notwithstanding the circumstances resulting in the termination, the corporation will be
treated as continuing to be an S corporation during the period specified by the
Secretary.

Rev. Proc. 2002-69, 2002-2 C.B. 831, provides guidance on the classification of a
business entity owned by a husband and wife as community property. If the husband
and wife treat a qualified entity as a disregarded entity for federal income tax purposes,
the Service will respect that treatment. If the husband and wife treat a qualified entity as
a partnership for federal income tax purposes and file appropriate partnership returns,
the Service will respect that treatment. A change in reporting position will be treated as
a conversion of the entity. A business entity is a qualified entity if (1) it is wholly owned
by a husband and wife as community property under the laws of a state, a foreign
country, or a possession of the United States; (2) no person other than one or both
spouses would be considered an owner for federal tax purposes, and (3) the business
entity is not treated as a corporation under § 301.7701-2.

                                  CONCLUSION

Based solely on the information submitted and the representations made, we conclude
that if X’s conversion from a State corporation to a State limited partnership on Date 2
did create a second class of stock, then the consequent termination of X’s S corporation
election was inadvertent within the meaning of § 1362(f). We further conclude that X’s
S corporation election, if not otherwise terminated, would have terminated on Date 3
when C became a partnership and was therefore an ineligible shareholder of X.
However, we also conclude that such termination was inadvertent within the meaning of
§ 1362(f). Accordingly, pursuant to the provisions under § 1362(f), X will be treated as
continuing to be an S corporation on Date 2 and thereafter provided that X’s S
corporation election was valid and not otherwise terminated under § 1362(d).

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.

Except as specifically ruled above, we express or imply no opinion as to the federal
income tax consequences of the facts described above under any other provision of the
Code. Specifically, we express or imply no opinion regarding X’s eligibility to be an S
corporation.

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This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) 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,



                                                 __________/s/____________
                                                 Jennifer N. Keeney
                                                 Senior Counsel, Branch 1
                                                 Office of the Associate Chief Counsel
                                                 (Passthroughs and Special Industries)

Enclosure
Copy of letter for § 6110 purposes
cc: ----------------------------------
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