Relief for ESBT election failure saves S corporation's status: The lapse is ruled an inadvertent termination.

Author:McCoon, Mark A.

An IRS letter ruling allowed an otherwise qualified corporation to continue to be treated as an S corporation for federal income tax purposes despite its inadvertent termination of its S corporation status. The inadvertent termination was triggered by the actions of the trustees of two of the corporation's shareholders. The trustees failed to make the required electing small business trust (ESBT) elections. Failing to make the election resulted in the corporation's having unqualified shareholders, thus resulting in an involuntary termination of the corporation's Subchapter S status.

The corporation had elected to be taxed as an S corporation. One of the corporation's shareholders, an individual, transferred his or her shares to a revocable trust. The trust was a grantor trust under Sec. 671. Grantor trusts are qualified S corporation shareholders under Sec. 1361(c)(2)(A)(i). Upon the death of the grantor, the assets of the grantor trust, including stock in the corporation, were distributed to two new trusts. The new trusts both met the requirements to be treated as ESBTs under Sec. 1361(c)(2)(A)(v).

However, the trustees of the two trusts failed to timely file ESBT elections, which would have resulted in the trusts' being treated as qualified S corporation shareholders. Without the timely election, the corporation's S election terminated on the date of the transfer of the stock. The corporation's S election was involuntarily terminated because the trusts were ineligible shareholders. Subsequently, upon discovery that ESBT elections were not timely filed, the two trusts filed elections to be treated as ESBTs. The trusts further represented that they filed all tax returns consistent with their being ESBTs. Additionally, the corporation asserted that it filed its tax returns consistent with being an S corporation.

Under Sec. 1361(b)(1)(B), S corporations are limited as to the type and number of shareholders they can have. Qualified S corporation shareholders are...

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