C and S Corporations for Estate Planners, Mini-Feature: PLR 202407005
Analyzing inadvertent terminations from trust and estate administrations
This is a part of the series on C and S corporations for estate planners. For the series index and first article, click here. For the prior article, click here.
Intro
In subsequent articles, we will discuss in greater detail the eligible shareholder requirements for S corporations under IRC Section 1361. But, a recent private letter ruling (PLR 202407005) shines light on an important point where trusts and S corporations are involved.
Generally, IRC Section 1361(b) requires at all times that an S corporation have only eligible shareholders. Any transfer of shares to an ineligible shareholder, even if momentary, can terminate an otherwise-valid S corporation election. In addition, the presence of a C corporation shareholder who is ineligible can prevent the C corporation from qualifying for the S corporation election to begin with.
While perhaps overly-simplified, only individuals who are U.S. citizens or residents can be eligible shareholders. There are some exceptions, such as for an estate and certain tax-exempt organizations (excluding non-grantor split-interest trusts). But, where this often rears its ugly head in the estate planning and administration context is where trusts are involved.
Generally, in order for a trust to be a shareholder, there must be a way to look through the trust to treat the grantor, or one or more beneficiaries, as the deemed income tax owners of the shares. This usually requires the use of one of three types of trusts:
A trust under which all shares are deemed owned by the grantor or a beneficiary under the grantor trust rules of IRC Sections 671-678;
A qualified subchapter S trust (QSST); or
An electing small business trust (ESBT).
I will discuss these trusts in greater detail in subsequent articles, but for the time being there are administrative filing requirements for both a QSST and ESBT. In particular, no later than 2 months and 16 days after S corporation stock is first transferred to the trust (including the date of transfer), an election must be made to treat the trust as a QSST or ESBT (assuming the trust qualifies to begin with - a subject for subsequent articles). This election requires filing a statement with the IRS, which is usually a separate written statement for which no form or part thereof is provided if an S election is not being made concurrent with the transfer of shares to the trust.
Background
The sheer number of trusts involved in this private letter ruling highlighted the importance of administrative “checks” where S corporation stock is involved.
To begin with, the shares were held by a revocable trust - which is treated as a grantor trust under IRC Section 676 (due to the right to revoke) and thus an eligible shareholder. Upon the death of the settlor of the revocable trust, a Code Section 645 election was made (another subject for another time) which treated the settlor’s estate as the new shareholder. Recall above that an estate can be a shareholder, at least for a limited period of time for administering the estate.
The death of the settlor itself, however, was not the issue. Instead, after the estate and revocable trust were administered, the revocable trust was divided into 9 subtrusts. Of those 9 trusts, 8 were intended to be QSSTs and the 9th was intended to be an ESBT.
The problem, however, was that no QSST elections were made by the current income beneficiaries of the respective QSSTs. Further, the ESBT election was not made by the trustee. By the time this was discovered, the 2-month-16-day filing deadline had passed, resulting in an inadvertent termination of the S corporation election. As mentioned in the last article, this causes the entity (even if not a state-law corporation) to revert back to C corporation tax status.
Relief
The IRS gives fairly generous relief for inadvertent terminations, depending on how much time has passed. We will discuss the specific timing mechanisms in a later article, but if too much time has passed a request for relief in the form of a private letter ruling must be made. This carries with it the fees of having an attorney or tax professional prepare the ruling request, along with a user fee charged by the IRS.
But, the fees are not the end. You usually must also show facts that the termination due to failure to make a timely election was, indeed, inadvertent, which requires no tax avoidance purpose or retroactive tax planning. What often helps here is the S corporation continuing to file the appropriate returns during the post-termination period.
Luckily, in this ruling, the IRS determined that the termination was inadvertent. As a result, the S corporation’s election was deemed to be valid relating back to the date of termination, but contingent on the filing of all QSST and ESBT elections within 120 days of the issuance of the PLR.
Takeaways
It is easy when administering an estate or revocable trust to ignore or disregard the effects on an S corporation election - especially when the decedent was not involved in the ongoing management or governance of the S corporation itself. While K-1s received by the decedent, estate, or revocable trust should create this awareness, the executor or successor trustee must know enough to request this information to begin with.
With shares in an actual corporation, this can create a sufficient hint to check for any existing S corporation election. But, where you have a state-law LLC or partnership that has made an S corporation election, the possibility of an existing S corporation election may be less apparent.
In any case, the ultimate transfer of interests to subtrusts at the end of estate/trust administration starts the ticking of a clock to make the appropriate election. It may also require coordination with the tax filer for the S corporation itself, to determine whether an S corporation short year will be created (a subject for a later article).
And, as noted in this ruling, the responsibility for the QSST or ESBT election may not fall on the executor or administrative trustee who is transferring shares or interests to the subtrusts. It may, instead, fall to the current income beneficiary (not trustee) of the QSST or the trustee of the ESBT. This mismatch of responsibility, if not communicated, can lead to a scenario such as we saw in this PLR.