Defective trusts that ended a company's S corporation status are excused after being fixed

Plain-English summary

An S corporation's two shareholders set up trusts for their children and transferred their company stock into them. The trusts were meant to be qualified subchapter S trusts (QSSTs), which are permitted S corporation shareholders, but the trust documents did not actually satisfy the QSST requirements in Code section 1361(d)(3). Because a trust that is not a permitted shareholder disqualifies the company, the transfer automatically terminated the company's S corporation election. When the company discovered the problem, it retroactively amended the trust agreements so each would qualify as a QSST, and it asked the IRS to treat the lapse as an inadvertent termination under section 1362(f). The IRS agreed the termination was inadvertent and granted relief: the company is treated as having remained an S corporation from the date of the transfer forward, so long as its election was otherwise valid. This is the standard fix when a poorly-drafted trust unintentionally knocks out a business's pass-through tax status.

Ruling snapshot

• Question: Was the termination of the company's S corporation election, caused by transferring stock to trusts that did not meet the QSST requirements, inadvertent and eligible for relief under § 1362(f)?
• Outcome: Approved (relief granted; company treated as a continuing S corporation)
• Key authorities: IRC §§ 1361(b), 1361(c)(2), 1361(d)(3), 1362(d)(2), 1362(f); Rev. Rul. 93-79

Full text (IRS public release)

Internal Revenue Service                                        Department of the Treasury
                                                                Washington, DC 20224

 Number: 202451004                                              Third Party Communication: None
 Release Date: 12/20/2024                                       Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.01-02,
               1362.02-00, 1362.04-00                           Person To Contact:
                                                                ------------------------, ID No. -----------------
 ----------------------------------------                       Telephone Number:
 -------------------------------                                --------------------
 ----------------------------------                             Refer Reply To:
 ----------------------                                         CC:PSI:B03
 -----------------------------------                            PLR-105736-24
                                                                Date:
                                                                September 24, 2024




LEGEND

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

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

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

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

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

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

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

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

Year         = -------

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

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

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

Trust 2      = ----------------------------------------------
PLR-105736-24                                     2

                -----------------------

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

       This letter responds to a letter dated March 21, 2024, and subsequent
correspondence, submitted on behalf of X and its authorized representative, requesting
a ruling under § 1362(f) of the Internal Revenue Code (Code).

                                               FACTS

       According to the information submitted, X was incorporated under the laws of
State on Date 1. X elected to be an S corporation effective Date 2. On Date 3,
shareholders A and B established Trust 1 and Trust 2, and subsequently on Date 4 A
and B transferred shares of X to Trust 1 and Trust 2. Trust 1 and Trust 2 were intended
to be qualified subchapter S trusts (QSST) for the benefit of the children of A and B, but
the governing provisions of Trust 1 and Trust 2 did not satisfy the requirements under
§ 1361(d)(3). Consequently, upon the transfer of shares on Date 4, Trust 1 and Trust 2
became ineligible shareholders of X and X's S corporation election terminated.

        In Year, X discovered that its S corporation election terminated on Date 4, and
that Trust 1 and Trust 2 were ineligible shareholders of X. Subsequently, on Date 5 the
trust agreements for Trust 1 and Trust 2 were modified retroactively to ensure they each
qualified as a QSST effective Date 3 pursuant to the modification agreement.

        X represents that all relevant times, X and its shareholders intended for X to be
an S corporation effective Date 3 and that X, and Trust 1 and Trust 2 have filed federal
tax returns consistent with X being an S corporation. X represents that the termination
of its S corporation election on Date 4 was inadvertent and was not motivated by tax
avoidance or retroactive tax planning. 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) 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, 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.
PLR-105736-24                                  3

        Section 1361(c)(2)(A)(i) provides that, for the purposes of § 1362(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, may be an S
corporation shareholder.

       Section 1361(d)(1) provides that a QSST who beneficiary makes an election
under § 1361(d)(2) will be treated as a trust described in §1361(c)(2)(A)(i), and the
beneficiary of such trust will be treated as the owner (for purposes § 678(a)) of that
portion of the trust which consists of stock in an S corporation with respect to which the
election under § 1361(d)(2) is made.

        Section 1361(d)(3) defines a QSST as a trust, (A) the terms of which require that
(i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust, (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary, (iii) the income interest of the
current beneficiary in the trust shall terminate on the earlier of such beneficiary's death
or the termination of the trust, and (iv) upon the termination of the trust during the life of
the current income beneficiary, the trust shall distribute all of its assets to such
beneficiary, and (B) all of the income (within the meaning of § 643(b)) of which is
distributed (or required to be distributed) currently to one individual who is a citizen or
resident of the United States.

       Section 1362(d)(2)(A) provides that an election under § 1362(a) will be
terminated whenever (at any time on or after the first day of the first 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), (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
the termination, steps were taken so that the corporation for which the termination
occurred is once a small business corporation, and (4) the corporation for which the
termination occurred and each person who was a shareholder in the corporation at any
time during the period specified pursuant to § 1362(f), agrees to make 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 a
S corporation during the period specified by the Secretary.

       Rev. Rul. 93-79, 1993-2 C.B. 269, provides that a reformation of a trust to meet
the requirements of a QSST is recognized prospectively.
PLR-105736-24                                  4

                                       CONCLUSION

        Based solely on the facts submitted and the representations made, we conclude
that X's S corporation election terminated on Date 4 when Trust 1 and Trust 2 became
ineligible shareholders. We further conclude that the termination of X's S corporation
election on Date 4 was inadvertent with the meaning of § 1362(f). Pursuant to the
provisions of § 1362(f), X will be treated as continuing to be an S corporation from
Date 4 and thereafter, provided that X's S election was otherwise valid and was not
otherwise terminated under § 1362(d).

        Except as expressly provided herein, we express or imply no opinion concerning
the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter. Specifically, we express or imply no opinion regarding X's eligibility to be
an S corporation or Trust 1's and Trust 2's eligibility to be a QSST.

      The rulings contained in this letter are 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 request for rulings, 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 the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representative.


                                           Sincerely,




                                           Robert D. Alinsky
                                           Chief, Branch 3
                                           Office of the Associate Chief Counsel
                                           (Passthroughs & Special Industries)




Enclosure:
      Copy of this letter for § 6110 purposes
PLR-105736-24                                           5



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