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By David I. Kempler, Esq., and Elizabeth Carrott
Buchanan Ingersoll & Rooney PC, Washington, DC
In PLR 201351013, the IRS ruled that a corporation would
continue to be treated as an S corporation, where termination of
its S corporation status was inadvertent under §1362(f), due to the
receipt of passive investment income and accumulated earnings and
profits, provided that the S corporation election was not otherwise
terminated under §1362(d); and subject to conditions that the
corporation (i) make adjustments under §1362(f)(4), (ii) remit
payment within 120 days and (iii) make Regs. §1.1368-1(f)(3)
election and deemed distributions in stated amount. Because of the
highly technical nature of the S corporation rules, the provisions
permitting the IRS to waive an inadvertent termination provide an
important safety net.
Corporation made a valid S corporation election. For three
consecutive years, Corporation had passive investment income that
exceeded 25% of its gross receipts. Corporation also accumulated
earnings and profits for each of the years stated above. As a
result, Corporation's S election was automatically terminated under
Corporation represented that its tax advisors inadvertently
failed to inform it of the passive investment rules.
Additionally, Corporation represented that it has always intended
to maintain its S corporation status and that the termination of
its S election was inadvertent and did not involve retroactive tax
planning or tax avoidance. Further, Corporation represented that it
and its shareholder continued to consistently treat Corporation as
an S corporation. Finally, Corporation represented that it
and its shareholder have agreed to make any adjustments required as
a condition of obtaining relief under the inadvertent termination
rule of §1362(f).
Under §1361(a)(1), the term "S corporation" means, with respect
to any taxable year, a small business corporation for which an S
corporation election under §1362(a) is in effect for that year.
Section 1361(b)(1) defines a "small business corporation" as a
domestic corporation which is not an ineligible corporation and
which does not (i) have more than 100 shareholders, (ii) 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, (iii) have a nonresident alien as a shareholder, and
(iv) have more than one class of stock.
Section 1375 imposes a tax, computed at the highest corporate
income tax rate, on the income of an S corporation that has
accumulated earnings and profits at the close of a taxable year,
and that has gross receipts more than 25% of which are passive
investment income. Additionally, under §1362(d)(3)(A)(i), an S
corporation election will be terminated whenever the corporation
has (i) accumulated earnings and profits at the close of three
consecutive taxable years; and (ii) passive investment income that
exceeds 25% of its gross receipts for such years. As a general
rule, under §1362(d)(3)(C)(i), the term "passive investment income"
means gross receipts derived from royalties, rents, dividends,
interest, and annuities.
Notwithstanding the general rule terminating an S corporation
status due to receipt of excessive passive investment income and
accumulated earnings and profits, under §1362(f), the IRS may
permit S corporation status to continue and restore S corporation
status retroactively, if the following conditions are satisfied:
(i) the corporation previously made a valid S election; (ii) the
termination was triggered by an inadvertent act as determined by
the IRS; (iii) steps are taken within a reasonable period to
correct the condition that rendered the corporation ineligible to
be an S corporation; and (iv) the corporation and persons who were
shareholders during the period of the termination agree to make any
adjustments the IRS requires that are consistent with the treatment
of the corporation as an S corporation.
Regs. §1.1362-4(b) provides that the determination of whether a
termination was inadvertent for purposes of §1362(f) is made
by the IRS. The corporation has the burden of establishing that,
under the relevant facts and circumstances, the IRS should
determine that the termination was inadvertent. Under Regs.
§1.1362-4(b), the fact that the terminating event was not
reasonably within the control of the corporation and was not part
of a plan to terminate the election, or the fact that the
terminating event or circumstance took place without the knowledge
of the corporation, notwithstanding its due diligence to safeguard
itself against such an event or circumstance, tends to establish
that the termination of the election was inadvertent. The IRS
concluded that the termination of Corporation's S corporation was
inadvertent within the meaning of §1362(f) because Corporation was
not made informed of the passive investment rules by its tax
advisors and the termination was not part of any plan.
The IRS will not waive termination until a corporation corrects
the condition causing termination and comes back into compliance
with the S corporation eligibility requirements. Under Regs.
§1.1362-4(d), the IRS may require such adjustments as are
consistent with the treatment of the corporation as an S
corporation during the period specified by the IRS. The period for
adjustments may be retroactive to the event triggering the
The IRS conditioned its waiver of the termination upon
Corporation making such adjustments and remitting payments due as a
result of the adjustments. The IRS further conditioned waiver of
the termination on Corporation making an election under Regs.
§1.1368-1(f)(3) to distribute its accumulated earnings and profits
through a deemed dividend.
Although limited liability companies have slowly become the most
common form of business entity, S corporations are still common.
Because of the highly technical nature of S corporation rules,
there are many traps for the unwary. PLR 201351013 provides an
important reminder to shareholders of an S corporation that under
§1362(f) an inadvertent termination can be overcome if the entity
follows the steps outlined therein.
For more information, in the Tax Management Portfolios, see
Starr, Smith and Sobol, 730 T.M., S Corporations: Formation
and Termination, and in Tax Practice Series, see ¶4250,
Terminating and S Election.
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