PLR 202601001

S Corp Saved After Multiple Trust Transfers Trigger Termination

The IRS has granted "inadvertent termination" relief to Corporation X, allowing it to retain its S corporation status retroactively, provided it rectifies certain paperwork errors. The corporation's S election was jeopardized when shares were transferred to five trusts (Trusts 1-5), and the trustees neglected to file the necessary paperwork to designate the trusts as Electing Small Business Trusts (ESBTs).

The Administrative Failure: Missed Elections for Five Trusts

Corporation X, incorporated in State, had elected to be an S corporation effective Date 2. The situation that triggered the need for IRS intervention began on Date 3, when shares of Corporation X stock were transferred to five separate trusts, identified as Trust 1 through Trust 5. While Corporation X represented that each of these trusts qualified as an Electing Small Business Trust (ESBT) under Section 1361(e) of the tax code, the trustees failed to actually file the required elections under Section 1361(e)(3). Section 1361(e) defines the ESBT, which is a type of trust that is permitted to be an S corporation shareholder if the trustee elects for the trust to be treated as such. Without the election, however, the trusts became ineligible S corporation shareholders. This, in turn, caused an automatic termination of Corporation X's S corporation election on Date 3. Subsequent transfers of additional shares to these trusts on Dates 4 through 7 would have also triggered a termination of the S election had it not already been terminated on Date 3.

Legal Analysis: Why the Error Qualified as 'Inadvertent'

The previous section described how Corporation X's S corporation election was terminated when shares were transferred to trusts that failed to make timely elections to be treated as Electing Small Business Trusts (ESBTs). An S corporation, as defined in Section 1361(a)(1), is a small business corporation that has elected, under Section 1362(a), to be treated as such. To qualify as a small business corporation, under Section 1361(b)(1), a corporation cannot have more than 100 shareholders, have an ineligible shareholder (other than certain estates, trusts, or exempt organizations), have a nonresident alien as a shareholder, or have more than one class of stock.

Section 1361(c)(2)(A)(v) clarifies that an ESBT can be an S corporation shareholder. An ESBT, as defined in Section 1361(e)(1)(A), is a trust that meets specific requirements, including restrictions on who can be a beneficiary and how interests in the trust are acquired. Crucially, Section 1361(e)(3) mandates that the trustee of an ESBT must affirmatively elect for the trust to be treated as such. Treasury Regulation § 1.1361-1(m)(2)(i) details how the ESBT election is to be made: by filing a statement with the IRS Service Center where the S corporation files its income tax return.

Section 1362(f) provides a crucial relief provision. It states that the IRS can treat a corporation as still being an S corporation, even after a termination event under Section 1362(d)(2) (which occurs when the corporation ceases to be a small business corporation), if several conditions are met. These conditions are: (1) the S election was terminated; (2) the IRS determines the circumstances resulting in termination were inadvertent; (3) steps were taken within a reasonable time after discovery to correct the issue; and (4) the corporation and its shareholders agree to make any adjustments required by the IRS. X represented that the termination was not motivated by retroactive tax planning.

The Cure: 120 Days to File Corrective Elections

The IRS concluded that the termination of X's S corporation election was inadvertent under Section 1362(f), which allows the IRS to treat a corporation as continuing to be an S corporation despite a terminating event (s when the corporation ceases to be a small business corporation), if several conditions are met. These conditions are: (1) the S election was terminated; (2) the IRS determines the circumstances resulting in termination were inadvertent; (3) steps were taken within a reasonable time after discovery to correct the issue; and (4) the corporation and its shareholders agree to make any adjustments required by the IRS. X represented that the termination was not motivated by retroactive tax planning.

Accordingly, the IRS ruled that X will be treated as continuing to be an S corporation from Date 3 onward. This favorable ruling, however, was contingent on two key actions. First, the trustees of the five trusts must file Electing Small Business Trust (ESBT) elections, as defined under Section 1361(e)(3), for each trust with the appropriate IRS service center within 120 days of the date of the Private Letter Ruling. Section 1361(e)(3) requires the trustee to elect ESBT status within a specific timeframe. Second, the trusts must file returns, including amended returns, for the affected years with the appropriate service center, also within 120 days, to properly reflect their treatment as ESBTs effective Date 3. The IRS stipulated that a copy of the Private Letter Ruling should be attached to each ESBT election and the returns.

Taxpayer Impact: This ruling illustrates the critical importance of coordinating with trustees immediately upon transferring S Corp stock to estate planning vehicles to avoid costly PLR requests. Failing to make timely ESBT elections can trigger an S Corp termination and necessitate seeking relief from the IRS.