Transitory, insignificant momentary ownership of S-corp stock by an ineligible shareholder under the equity-compensation regulations does not terminate the S elections

Plain-English summary

An S corporation loses its S status if it ever has an ineligible shareholder,
such as a partnership. Here, two S corporations (Y and Z) ran equity
compensation plans that let employees of a related business, X, buy their
shares at fair market value. Because of how the tax regulations treat a company
using stock to pay for services (Treas. Reg. §§ 1.83-6(d) and 1.1032-3), each
share issued to an X employee was deemed to pass momentarily through X, which
at the relevant time was treated as a partnership, an ineligible S corporation
shareholder. The companies asked whether this deemed, split-second ownership by
an ineligible shareholder terminated Y's and Z's S elections. The IRS ruled it
did not: the momentary ownership exists only on paper to solve timing and basis
problems under sections 83 and 1032, is insignificant and transitory, and was
never intended to affect S corporation status. So, solely for purposes of
section 1361, the S elections of Y and Z are not terminated under section
1362(d)(2). The IRS expressed no opinion on how sections 83 and 1032 otherwise
apply to the plans.

Ruling snapshot

• Question: Does the deemed momentary ownership of Y and Z stock by an
  ineligible shareholder (X, a partnership), created by the equity-compensation
  regulations, terminate Y's and Z's S corporation elections?
• Outcome: Approved (ruled no termination under § 1362(d)(2)).
• Key authorities: IRC §§ 1361, 1362(d)(2), 83(h), 1032; Treas. Reg. §§
  1.83-6, 1.1032-3; Rev. Rul. 64-250; Rev. Rul. 2008-18.

Full text (IRS public release)

Internal Revenue Service                       Department of the Treasury
                                               Washington, DC 20224

Number: 202612005                  Third Party Communication: None
Release Date: 3/20/2026            Date of Communication: Not Applicable
Index Number: 83.00-00, 1032.00-00,
              1361.00-00, 1361.01-02,          Person To Contact:
              1362.02-00, 1362.02-02           ----------, ID No. --------
                                               Telephone Number:
                                               --------
                                               Refer Reply To:
                                               CC:PT&E:B01
                                               PLR-112688-25
                                               PLR-112690-25
                                               Date:
                                               December 19, 2025


                                    LEGEND

X               = --------
Y               = --------
Z               = --------
Individual      = --------
State 1         = --------
State 2         = --------
Date 1          = --------
Date 2          = --------
Date 3          = --------
Date 4          = --------
Date 5          = --------
Date 6          = --------
Date 7          = --------
Date 8          = --------
Date 9          = --------
Plan 1          = --------
Plan 2          = --------


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

       This responds to a letter dated June 23, 2025, submitted on behalf of Y and Z by
their authorized representatives, requesting a ruling under § 1362(d)(2)(A) of the
Internal Revenue Code (Code).

                                    FACTS

       According to the information submitted, X was organized under the laws of
State 1 on Date 1 and made an election to be treated as an S corporation on Date 2.

       As part of a transaction intended to qualify as a reorganization under
§ 368(a)(1)(F), X formed Y, a corporation organized under the laws of State 2, on Date
3 and X shareholders exchanged all their stock in X for all the stock in Y. Y filed a Form
8869, Qualified Subchapter S Subsidiary Election, for X to be treated as a qualified
subchapter S subsidiary (QSub) within the meaning of § 1361(b)(3). Following the
transaction, all Y stock has been owned by Individual and other U.S. individuals,
including certain employees of X.

      Consistent with Rev. Rul. 64-250, 1964-2 C.B. 33 and Rev. Rul. 2008-18, 2008-1
C.B. 674, Y succeeded in X's election to be treated as an S corporation as of Date 2.
On Date 4, X converted to a limited liability company.

       Z was organized under the laws of State 2 on Date 5 and made an election to be
treated as an S corporation effective Date 5. Since its formation, all Z stock has been
owned by Individual and other U.S. individuals, including certain employees of X. Z
acquired interests in X on Date 5, and X was treated as a partnership for federal tax
purposes effective Date 5.

      Y and Z adopted equity compensation plans, Plan 1 and Plan 2, respectively,
pursuant to which X employees would have the right to purchase shares thereof at fair
market value.

       With respect to Y, X employees received shares pursuant to the Plan 1 on Date
6, Date 7, Date 8, and Date 9 (collectively, "Y Plan Equity Grants").

       With respect to Z, X employees received shares pursuant to the Plan 2 on Date 9
("Z Plan Equity Grant", and collectively with Y Plan Equity Grants, the "Plan Equity
Grants").

       Each Plan Equity Grant allowed X to provide cash to Y and Z such that Y and Z
could issue shares to employees on behalf of X as compensation for services provided
to X.

        The operation of Plan 1 and Plan 2 and § 1.83-6(d) and § 1.1032-3(a)-(c) (or the
principles of such sections), as described below, would cause X to be deemed a
momentary owner of the stock of Y and Z, as the case may be. X, treated as a
partnership for federal income tax purposes at the time of each Plan Equity Grant, is an
ineligible S corporation shareholder.

                              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 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 1362(d)(2) provides that an S corporation election 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 83(h) and § 1.83-6(a)(1) of the Income Tax Regulations provide that, in
the case of a transfer of property to which § 83 applies, the person for whom were
performed the services in connection with which the property was transferred is allowed
a deduction in an amount equal to the amount included under § 83(a), (b), or (d)(2) in
the gross income of the person who performed the services.

      Section 1.83-6(d)(1) provides that a transfer of property by a shareholder of an
employer to a service provider or employee as payment for services is treated as a
capital contribution by the shareholder to the corporation and then a transfer from the
corporation to the service provider of such property. Section 1.83-6(d)(1) cross
references § 1.1032-3 in discussing the treatment of a corporation transferring its own
shares as compensation to someone who provides services to another corporation or
partnership.

        Section 1.1032-3(a) provides that the recharacterization of transactions under
§ 1.1032-3 applies to transactions in which a corporation or a partnership (the acquiring
entity) acquires money or other property in exchange, in whole or in part, for stock of
another corporation (the issuing corporation).

       Section 1.1032-3(b) provides that if the rules of § 1.1032-3 apply, then the
"transaction is treated as if, immediately before the acquiring entity disposes of the
stock of the issuing corporation, the acquiring entity purchased the issuing corporation's
stock from the issuing corporation for fair market value with cash contributed to the
acquiring entity by the issuing corporation (or, if necessary, through intermediate
corporations or partnerships)." Section 1.1032-3(e) provides examples illustrating how
these rules apply in the context of a compensatory arrangement in which stock is issued
to a service provider of a subsidiary entity of the issuing company (see Examples 4 and
5).

        Section 1.1032-3(c) provides that the recharacterization of transactions under
§ 1.1032-3 applies to transactions only when the acquiring entity acquires issuing
corporation stock in a transaction in which the acquiring entity's basis in the stock would
otherwise be determined with respect to the issuing corporation's basis in the stock
under § 362(a) or § 723; the acquiring entity immediately transfers the stock to acquire
money or other property; the party receiving the stock from the acquiring entity does not
receive a substituted basis; and the issuing corporation stock is not exchanged for stock
of the issuing corporation.

       While §§ 83 and 1032 and the regulations thereunder may not be directly applied
to each Plan Equity Grant, the transactions described herein may be governed by their
principles.

       Section 83(h) and § 1.83-6(a)(1) function to match the timing of the service
recipient's deduction for compensation paid to the timing of the income recognized by
the service provider that receives the compensation. The deemed transaction created
by § 1.83-6(d) directly links the parties receiving and providing services in exchange for
the compensation and establishes the timing match for income and deduction related to
compensation paid. Section 1.1032-3 extends the nonrecognition treatment of § 1032
to cover a subsidiary's use of parent stock to acquire property and pay compensation if
certain specified conditions are satisfied. Section 1.1032-3 allows the purchase of
property by a subsidiary using parent stock to be treated the same as the purchase of
the property by the parent using its own stock followed by the parent transferring the
property to its subsidiary. This treatment is achieved by characterizing the transaction,
if certain specified conditions described in § 1.1032-3(c) are satisfied, as a deemed
contribution of cash from a parent to its subsidiary and then the immediate deemed
purchase of stock of the parent by the subsidiary with the deemed contributed cash.
This approach is also adopted by section 1.1032-3 for compensatory payments by a
subsidiary using its parent's stock and by cross-reference in § 1.83-6. The approach in
these regulations gives the subsidiary a cost basis in the parent stock immediately
before using it to purchase property or compensate a service provider so the subsidiary
does not recognize gain on the transfer of the parent stock. The deemed transactions
and resulting momentary ownership solely created by § 1.83-6 and § 1.1032-3 are
transitory, created to solve timing and basis concerns arising from §§ 83 and 1032, and
were not intended to impact S corporation election status.

                                 CONCLUSION

       Based solely on the facts submitted and the representations made, we conclude
that the Plan Equity Grant transfers of Y or Z stock by X to employees that provide
services to X under Plan 1 and Plan 2 cause momentary ownership of stock of Y and Z
by ineligible S corporation shareholders pursuant to § 1.83-6(d) and § 1.1032-3(a)-(c)
(or the principles of such sections). Solely for purposes of § 1361, the momentary
ownership by such ineligible shareholders resulting from the operation of § 1.83-6(d)
and § 1.1032-3(a)-(c) (or the principles of such sections), which is insignificant and
transitory, does not result in a termination of Y or Z's S elections under § 1362(d)(2).

       Except as specifically ruled on above, we express or imply no opinion concerning
the federal income tax consequences of the facts of this case under any other provision
of the Code. Specifically, we express or imply no opinion concerning the application of
§§ 83 and 1032 and the regulations thereunder, or the principles of such sections, to
Plan 1 and Plan 2 beyond that they could apply in certain instances where Y and Z
shares are transferred to service providers of X, an ineligible shareholder, to cause
deemed momentary ownership of Y and Z stock by X. We also express or imply no
other opinion as to the federal income tax consequences to X, Y, and Z of the transfer
of Y and Z stock pursuant to Plan 1 and Plan 2.

       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 an appropriate party. While this office has not verified any of the material submitted
in support of the requested ruling, 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 a power of attorney on file, a copy of this letter is being sent to your
authorized representatives.


                                            Sincerely,



                                            __________________________
                                            Caroline E. Hay
                                            Senior Technician Reviewer, Branch 1
                                            Office of the Associate Chief Counsel
                                            (Passthroughs, Trusts, and Estates)


      Enclosure:
Copy of this letter for section 6110 purposes

cc:       --------