S Corporations have strict requirements to maintain their status for tax purposes, including being limited to 100 U.S. resident individual shareholders, having only one class of stock outstanding, and being required to allocate profits and losses in strict proportion to share ownership. Many taxpayers unintentionally violate these requirements in the normal operation of business or through estate conveyances. For example, paying one shareholder more than reasonable compensation for services or reimbursing personal expenses for one shareholder could create a second class of stock, which would inadvertently invalidate the S-election. With the release of PLR 202506003 on Feb. 7, 2025, and PLR 202349005 on Dec. 8, 2023, the IRS appears to be widening the circumstances when a taxpayer can claim inadvertent termination of an S corporation. This is helpful for taxpayers who currently own or are purchasing an S corporation.
In PLR 202349005, Company X was treated as an S corporation. When Shareholder A died, his shares were transferred to a qualified terminable interest property (QTIP) trust for the benefit of Person B. Person B properly made an election for the QTIP to be treated as a qualified subchapter S trust (QSST) under Section 1361(d)(2). When Person B subsequently passed away, the QSST election ceased to be valid, and Person B’s estate became the beneficiary of the QTIP trust. However, the estate did not make a proper QSST or small business trust (ESBT) election within two years of Person B’s death (as required by Reg. Section 1.1361-1(j)(7)(ii)), which resulted in the termination of Company X’s status as an S corporation. The IRS held that the QTIP trustee’s failure to make a new ESBT election was inadvertent under Section 1362(f), and Company X could maintain its status as an S corporation as long as the trustee of the QTIP filed an ESBT election within 120 days of the PLR being issued.
In PLR 202506003, Company X had an equity compensation plan (Plan) that allowed either Company X or Shareholder A, a majority shareholder in Company X, to provide employees or service providers of Company X (and its subsidiaries) with equity in Company X in exchange for the services provided. Shareholder A also had interests in other entities (Related Entities) that participated in the same Plan, such that the interests of Company X would be provided by Company X or Shareholder A to employees or service providers of the Related Entities. Company X then undertook certain restructuring steps, which resulted in a newly created parent company that was also covered by the Plan. Due to the mechanics under Treas. Reg. 1.83-6(d) and 1.1032-3(a) – (c), the transfer of Company X stock pursuant to the Plan could cause Company X to terminate its S corporation status because of deemed momentary ownerships by the Related Entities, many of whom were ineligible shareholders. The IRS concluded that such momentary ownership was insignificant and transitory and, therefore, it would not result in the termination of Company X’s S-election under Section 1362(d).
Rev. Proc. 2022-19 offers relief in many situations where there has been an ineffective S-election or inadvertent termination; however, these cannot cover every situation. The good news is that the IRS appears to be loosening the demands of perfection for a company to maintain S corporation status, as long as there is (i) evidence of the termination being inadvertent, (ii) the actions taken were not motivated by tax avoidance or to circumvent the S corporation taxation requirements, and (iii) the activity that occurred to terminate the S corporation status was insignificant and transitory. Though PLRs are helpful and indicative of an IRS position on an issue, they cannot be relied on as precedent by other taxpayers or IRS personnel. As a result, we recommend that taxpayers always use experienced tax advisors to assist them with business planning involving S corporations, as emphasized by these situations involving individual estate planning and implementing equity compensation programs.
Questions?
For any questions about maintaining your S corporation status, connect with a CBIZ tax professional today.
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