PLR 9946028: Relief restores S corporation treatment after ineligible owner joins

Plain-English summary

A company that had elected S corporation status converted to a state law limited partnership and elected corporate classification for federal tax purposes. Another corporation contributed cash for an interest, making it an ineligible S corporation shareholder and ending the S election. Once the company discovered the problem, two shareholders acquired that corporation’s interest. The IRS found the termination inadvertent and allowed S corporation treatment for the affected period and afterward, provided the election does not otherwise terminate and all parties report consistently with that treatment. It did not decide whether the conversion qualified as a reorganization under § 368(a)(1)(F).

Ruling snapshot

• Question: Can the company receive inadvertent termination relief after a corporate owner briefly held an interest?
• Outcome: Approved: S corporation treatment continues for the affected period, subject to consistent reporting and the election's other requirements.
• Key authorities: IRC §§ 1361, 1362(f), 1366–1368, and 368(a)(1)(F); Treas. Reg. § 301.7701-3.

Full text (IRS public release)

199946028

Internal Revenue Service
Department of the Treasury
Index Number: 7701.00-00; 1362.04-00
Washington, DC 20224

Person to Contact:
Telephone Number:
Refer Reply To:
CC:DOM:P&SI:03-PLR-107407-99
Date: August 5, 1999

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Company =
Corporation =
State =
Shareholders =
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PLR-107407-99 2 199946028

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A =
B =
d1 =
d2 =
d3 =
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d6 =

Dear

This letter responds to a letter dated d6, on behalf of Company, requesting relief under § 1362(f) of the Internal Revenue Code.

FACTS

According to the information submitted, Company was incorporated under the laws of State on d1. Company subsequently elected to be treated as an S corporation as defined in § 1361(a) effective on d2. ;

On d3, Company converted to a limited partnership under the laws of State with the Shareholders retaining their proportionate interests. Pursuant to the conversion, Corporation also contributed cash to Company in exchange for an interest. For purposes of local law, Corporation was considered the sole general partner while the Shareholders were considered limited partners, however, all interests provided identical rights to operating and liquidating distributions. On or about d4, Company filed a Form 8832 (Entity Classification Election) electing to be classified as an association taxable as a corporation for all federal tax purposes effective for the start of its existence as a State law limited partnership. Company represents that the conversion was a reorganization within the meaning of § 368(a)(1)(F).

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In conjunction with the preparation of the Form 8832, Company became aware that Corporation was an ineligible shareholder. On d5, two of the Shareholders, A and B (acting through their respective disregarded limited liability companies), acquired Corporation's interest in Company.

Company did not know that admitting Corporation as a general partner would terminate its S election. Company’s admission of Corporation was not motivated by federal income tax avoidance or retroactive federal income tax planning. Company and each of its shareholders who were shareholders during the termination period agree to make any adjustments consistent with the treatment of Company as an S corporation.

LAW AND ANALYSIS

Company converted from a corporation to a limited partnership under the laws of State and elected under § 301.7701-3 to be classified as an association taxable as a corporation for federal tax purposes. Company has represented that the conversion qualified as a reorganization under § 368(a)(1)(F). If the conversion qualified as a reorganization under § 368(a)(1)(F), then the conversion would not have terminated Company's S corporation election provided Company still met the requirements of an S corporation under § 1361. See Rev. Rul. 64-250, 1964-2 C.B. 333.

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)(B) provides that a "small business corporation" means a domestic corporation that is not an ineligible corporation and that does not 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.

Section 1362(d)(2) specifies that a corporation's election under § 1362(a) will terminate 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(f) provides in 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 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 the adjustments (consistent with the treatment of the corporation as an S corporation) as

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may be required by the Secretary for that period, then, notwithstanding the circumstances resulting in such termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.

CONCLUSION

After applying the relevant law to the facts submitted and the representations made, we conclude that Company's election to be an S corporation terminated as of d3 when Corporation acquired an interest in Company. We also hold that the termination was inadvertent within the meaning of § 1362(f).

We further hold that under the provisions of § 1362(f), Company will be treated as an S corporation during the period of d3 through d5, and thereafter, provided Company's S corporation election does not otherwise terminate under § 1362(d). Accordingly, in determining their federal tax liability for the period from d3 to d5, the Shareholders and Corporation must include their pro rata share of the separately and nonseparately computed items of Company under § 1366, make adjustments to stock basis under § 1367, and take into account any distributions made by Company under
§ 1368. If Company, the Shareholders, or Corporation fail to treat Company as described above, this ruling shall be null and void.

Except as specifically set forth above, we express no opinion concerning the federal tax consequences of the transactions described above under any other provision in the Code. In particular, no opinion is expressed on whether the conversion qualified as a reorganization under § 368(a)(1)(F).

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This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

PLR-107407-99

Sincerely yours,

(signed) William P. O'Shea

William P. O’Shea

Chief,

Branch 3

Office of the Assistant
Chief Counsel
(Passthroughs and Special
Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes