Inadvertent Termination of S Election

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Gregory W. Mitchell

Gregory W. Mitchell

Attorney

469.998.8486
gmitchell@freemanlaw.com

Gregory Mitchell joins Freeman Law to lead its bankruptcy practice. Mr. Mitchell is a native of the Dallas area, graduating from Southern Methodist University with a Bachelor’s Degree in Economics in 1991 and with his J.D. in 1994. In 1995, he obtained an LL.M. in Taxation from New York University. Mr. Mitchell currently directs the SMU Dedman School of Law’s federal taxpayer clinic. Mr. Mitchell’s background in tax makes him a natural fit for Freeman Law.

Prior to joining Freeman Law, Mr. Mitchell was the managing partner of The Mitchell Law Firm, L.P., a small firm he started in 2004, where he ran a diverse practice primarily focused on bankruptcy, tax and related litigation matters.

Prior to starting his own firm, Mr. Mitchell served as a Partner and General Counsel with Tax Automation, L.P., a national tax consulting firm. Mr. Mitchell was previously the National Director of Tax Technology at Ryan & Company, a national tax consulting practice, as well as a Senior Manager with KPMG, a “Big Four” accounting firm.

Private Letter Ruling 202244001, November 4, 2022

In a recent Private Letter Ruling, the Internal Revenue Service determined that termination of a corporation’s S election, due to the creation of more than one class of stock or due to trusts becoming ineligible shareholders, was inadvertent under I.R.C. §1362(f). Therefore, the corporation would continue to be treated as an S corporation.

 

The requesting S Corporation (“Company”) elected to be treated as an S Corporation several years ago. At that time, the only shareholders of the Company were two individuals – A and B.

 

Sometime later, the Company converted from a corporation to a limited partnership under state law, and filed a Form 8832, Entity Classification Election, to be classified as an association taxable as a corporation. The Company represented in its private letter ruling (PLR) request that the conversion qualified as a reorganization under § 368(a)(1)(F) and Company therefore continued as an S corporation. After the conversion, Company’s limited partners were individuals A and B, and Company’s general partners were Y and Z. Y and Z were both limited liability companies formed under state law and treated as entities disregarded from individuals A and B, respectively, for federal tax purposes.

 

Following the conversion, the partners of Company entered into a new partnership agreement, Revised Partnership Agreement. This agreement contained provisions in contemplation of Company being treated as a partnership for federal income tax purposes, including that capital accounts be maintained and that liquidating distributions of the partnership be made in accordance with the partners’ positive capital account balances. The conversion to a limited partnership under state law 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 Company’s S corporation election to terminate. In addition, the provisions in the Revised Partnership Agreement gave rise to a second class of stock causing Company’s S corporation election, if not otherwise terminated, to terminate at that time. However, Company represented in its PLR Request that any second class of stock was created inadvertently.

 

Subsequently, A gifted A’s limited partnership interest in Company to Trust 1, Trust 2, and Trust 3. Simultaneously, A gifted A’s interest in Y to Trust 1 and Trust 2. Because of this transfer, Y changed from being treated as a disregarded entity to being treated as a partnership. Subsequent to A’s gifting, Trust 3 merged with and into Trust 4. As a result of this merger, Trust 3’s interest in Company became the property of Trust 4. Company represented in its PLR request that Trusts 1, 2, 3, and 4 each met the definition of an Electing Small Business Trust (ESBT) under § 1361(e)(1). However, the respective trustees failed to make timely ESBT elections for the trusts under § 1361(e)(3). As a result, Company had ineligible shareholders in violation of §1361(b)(1)(B) and Company’s S corporation election would have terminated on the time of the gifting as well as at the time of the merger between Trust 3 and Trust 4. However, Company represented in its PLR request that the failure to make ESBT elections was inadvertent.

 

Finally, Company also represented in its PLR Request that when A’s interest in Y was gifted to Trust 1 and Trust 2, Y converted from being treated as a disregarded entity to being treated as a partnership for federal tax purposes and therefore was an ineligible shareholder under § 1361(b)(1)(B), also causing Company’s S corporation election to terminate at that time. However, Company represented in its PLR request that it was unaware of that consequence of the transfer and that the change to a partnership was inadvertent.

 

Upon discovering that it had ineligible shareholders and more than one class of stock, Company took the following actions:

  1. Y’s general partnership interest was converted to a limited partnership interest and was distributed out to Trust 1 and Trust 2 such that Y was no longer a shareholder. Simultaneously, Z’s general partnership interest was converted to a limited partnership interest and distributed out to B such that Z was no longer a shareholder. In addition, language contained in the Revised Partnership Agreement in contemplation of Company being treated as a Partnership for federal tax purposes was removed and new language contemplating Company being treated as an S corporation for federal tax purposes was inserted.
  2. Trust 1 purchased Trust 4’s limited partnership interest in Company and also purchased a portion of B’s limited partnership interest in Company.  Simultaneously, Trust 2 purchased a portion of B’s limited partnership interest in Company. After these purchases, Trust 1, Trust 2, and B were the only remaining shareholders of Company.
  3. Company then converted from a limited partnership to a limited liability company under state law. Company filed a Form 8832, Entity Classification Election, to be classified as an association taxable as a corporation.

 

Company represented in its PLR Request that there was no intent to terminate its S corporation election, and the inadvertent terminations were not motivated by tax avoidance or retroactive tax planning. Company and its shareholders have consistently treated Company as an S corporation and agree to make any adjustments consistent with the treatment of Company as an S corporation as may be required by the Secretary.

 

Analysis

  1. Section 1361(a)(1) of the Internal Revenue 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.
  2. Section 1361(b)(1) defines a “small business corporation” as a domestic corporation which is not an ineligible corporation and which does not:
    • have more than 100 shareholders;
    • 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;
    • have a nonresident alien as a shareholder; and
    • have more than one class of stock.
  3. Section 1361(c)(2)(A)(v) provides that, for purposes of § 1361(b)(1)(B), an ESBT may be a shareholder.
  4. Section 1361(e)(1)(A) provides that, except as provided in § 1361(e)(1)(B), the term “electing small business trust” 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.
  5. 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.
  6. Section 1.1361-1(I)(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.
  7. 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(d)(2)(B) further provides that the termination shall be effective on and after the date of cessation. 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 the 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 a small business corporation; and
    • (4) the corporation for which the termination occurred, and each person who was a shareholder of the corporation at any time during the period specified pursuant to  § 1362(f), agree to make the adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary regarding this period then, notwithstanding the circumstances resulting in the termination, the corporation shall be treated as an S corporation during the period specified by the Secretary.
  8. Section 1.1362-4(d) provides that the Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the Commissioner.

 

Takeaway

Based on the representations made and the information submitted in the PLR Request, the IRS concluded that if Company’s conversion from a corporation to a  limited partnership under state law did create a second class of stock, the consequent termination of Company’s S corporation election was inadvertent within the meaning of §1362(f).

 

The IRS further concluded that Company’s S corporation election, if not otherwise terminated, would have terminated on because the partnership provisions created a second class of stock. Additionally, it concluded that Company’s S corporation election, if not otherwise terminated, would have terminated because it had ineligible shareholders under § 1361(b)(1)(B) – Y became a partnership and was therefore an ineligible shareholder and the trustees of Trust 1, Trust 2, and Trust 3, failed to make ESBT elections thus the trusts were ineligible shareholders. Finally, the election also would have terminated on when Trust 3 merged into Trust 4 because the trustee of Trust 4 failed to make an ESBT election. However, based on information provided in the PLR Request, the IRS further concluded that such terminations were inadvertent within the meaning of § 1362(f). Pursuant to the provisions of § 1362(f), Company will therefore be treated as continuing to be an S corporation unless Company’s S corporation election is otherwise terminated under § 1362(d).

 

The ruling was held to be further contingent on:

  1. the trustees of Trust 1, Trust 2, and Trust 3 filing within 120 days from the date of this letter ESBT elections on behalf of their respective trusts with the appropriate service center;
  2. the trustees of Trust 4 filing within 120 days from the date of this letter an ESBT election on behalf of Trust 4 with the appropriate service center; and
  3. Trust 1, Trust 2, and Trust 4 filing within 120 days from the date of this letter amended returns for all open years to properly reflect the treatment of Trust 1, Trust 2, and Trust 4 as ESBTs – attaching a copy of this letter to any ESBT elections and income tax returns to which it is relevant.

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