IRS Grants Relief for Inadvertent Termination of S Corporation Election Due to Failed QSST Election

IRS Grants Relief for S Corporation After Failed QSST Election

The IRS granted § 1362(f) inadvertent termination relief to X, an S corporation, after Trust 2 failed to make a QSST election (§ 1361(d)) upon acquiring X stock. The IRS ruled that X’s S corporation election terminated inadvertently on Date 4, but relief is granted retroactively, treating X as an S corporation from Date 4 onward. Additionally, Trust 2 is treated as a QSST from Date 4 until Date 6, preventing further termination risks. The ruling underscores the IRS’s willingness to waive technical failures when taxpayers act in good faith and promptly correct issues.

The Question: Can X Regain S Corporation Status After Inadvertent Termination?

X sought IRS guidance under § 1362(f) to determine whether it could retroactively regain its S corporation status after its election terminated due to a missed Qualified Subchapter S Trust (QSST) election (§ 1361(d)). The taxpayer argued that the failure to file the QSST election was inadvertent—not motivated by tax avoidance or retroactive planning—and that it qualified for relief under § 1362(f), which permits the IRS to waive an S corporation termination if the failure was unintentional and promptly corrected.

The stakes were high: X’s S corporation election terminated automatically when Trust 2, its shareholder, failed to make the required QSST election upon acquiring the stock. Without relief, X would face C corporation tax treatment, exposing it to double taxation on corporate income and potential built-in gains tax under § 1374. The taxpayer’s request hinged on whether the IRS would accept that the missed election was a technical oversight rather than a deliberate strategy to avoid tax rules.

The Facts: A Timeline of Trusts, Elections, and Terminations

The sequence of events began with X’s incorporation and S corporation election. On Date 1, X was formed under State law and elected S corporation status effective Date 2, qualifying as a small business corporation under § 1361(a)(1) and § 1362(a).

Ownership shifted to Trust 1, a grantor trust described in § 1361(c)(2)(A)(i), of which H and W were deemed owners. Upon W’s death on Date 3, Trust 1 qualified under § 1361(c)(2)(A)(ii) as an eligible S corporation shareholder for a two-year period following W’s death, preserving X’s S status during that window.

On Date 4, assets—including X’s stock—were transferred to Trust 2 before the two-year eligibility period for Trust 1 expired. Trust 2 was eligible to be a QSST under § 1361(d), but H, the income beneficiary, failed to make the required QSST election under § 1361(d)(2). Because Trust 2 did not qualify as a permissible shareholder, X’s S corporation election terminated automatically on Date 4 under § 1362(d)(2).

H died on Date 5, triggering a potential two-year grace period under § 1.1361-1(j)(7)(ii) if Trust 2 had been a QSST. Instead, assets remained in Trust 2 until Date 6, when they were distributed equally to Trust 3, Trust 4, and Trust 5 (the Shareholder Trusts). Each Shareholder Trust met the QSST requirements under § 1361(d)(3) and filed late QSST elections under Rev. Proc. 2013-30 effective Date 6, retroactively curing the defect.

The Ruling: IRS Finds Termination Was Inadvertent

The IRS ruled that X’s S corporation election terminated on Date 4 when Trust 2, an ineligible shareholder, acquired stock in the company. However, the IRS determined that the termination qualified as inadvertent under § 1362(f), which permits the IRS to waive an S corporation termination if the failure was not intentional and the corporation acted in good faith.

Under § 1362(f), the IRS may treat the corporation as continuing to be an S corporation from the date of termination if the termination was inadvertent and the corporation corrects the issue. Here, the IRS concluded that X’s termination was inadvertent because Trust 2’s ineligibility arose from a failure to make a timely QSST election—a procedural defect rather than a deliberate act. The IRS granted relief by treating X as an S corporation from Date 4 onward, provided the election remained otherwise valid.

Additionally, the IRS ruled that Trust 2 would be treated as a QSST from Date 4 until Date 6, aligning with the retroactive QSST elections filed by the Shareholder Trusts. This treatment ensures continuity of S corporation status while addressing the trust’s eligibility issues.

The IRS explicitly declined to opine on other potential eligibility issues, stating that no opinion was expressed or implied regarding X’s compliance with other provisions of the Code. The ruling is limited solely to the inadvertent termination relief under § 1362(f).

Law and Analysis

The IRS applied § 1362(f) to determine whether X’s S corporation termination was inadvertent. Under § 1361(d), a trust may hold S corporation stock only if it qualifies as a QSST or ESBT. Trust 2’s failure to make a timely QSST election rendered it an ineligible shareholder, triggering automatic termination under § 1362(d)(2) on Date 4.

The IRS confirmed that the Shareholder Trusts qualified as QSSTs under § 1361(d)(3) upon retroactive election filings. The two-year post-death eligibility period in § 1.1361-1(j)(7)(ii) did not apply, as Trust 2’s noncompliance persisted beyond the grace period. Relief under § 1362(f) was granted because the failure to file QSST elections was inadvertent, promptly corrected via retroactive filings, and aligned with the trusts’ operational structure as QSSTs from Date 4 to Date 6.

Practical Guidance

This ruling highlights the need for strict adherence to QSST election deadlines and the risks of automatic termination for ineligible trusts. The IRS’s grant of relief underscores that good faith correction and prompt action can mitigate compliance failures, even after prolonged noncompliance.

Practitioners should:

• Monitor trust eligibility post-grantor death, particularly within the two-year window under § 1.1361-1(j)(7)(ii).
• File QSST elections within the 2-month-and-15-day deadline under § 1.1361-1(j)(6)(ii) to avoid inadvertent termination.
• Use Rev. Proc. 2013-30 for late elections, but only if the failure was inadvertent and corrected promptly.

Note: PLRs are non-precedential; outcomes depend on specific facts.

Key Takeaways

• File QSST elections within the 2-month-and-15-day deadline under § 1.1361-1(j)(6)(ii) to avoid inadvertent termination.
• Trusts have two years post-grantor death to qualify as QSSTs or ESBTs under § 1.1361-1(j)(7)(ii).
• Prompt corrective action is critical for relief under § 1362(f).
• Good faith and documentation are essential for substantiating inadvertent failures.