IRA: PLR 200802008* Inadvertently almost caused the Termination of S Corporation

Background:

An S corporation is a regular corporation that has elected a special tax status for federal income tax purposes. Rather than being taxed at the entity level, all items of income and deduction of S corporation are taxed at the shareholder level. (In effect, these items “flow through” to the shareholders.) “S” status is a privilege, and in order to maintain it, the corporation and shareholders must continue to meet stringent requirements.

In the facts of PLR 200802008*, S corp shares were issued to an individual retirement account (IRA) for the benefit of shareholder A. While certain qualified plans are permissible shareholders of S corps, an IRA is not a permissible shareholder. After a period of time, the shareholder (A) and the corporation realized this error. (The shares were subsequently distributed from the IRA to A.) Technically, the S election was inadvertently terminated at the moment the IRA acquired the shares.

However, under IRC Section 1362(f), the IRS may waive this result if the termination is truly found to be inadvertent. The IRS was willing to treat the corporation as a valid S corp from a stated date going forward, but subject to certain conditions. Two of the conditions were as follows. For the years that the corporation generated a loss, the IRA would be deemed the shareholder. For the years where the corporation generated a gain, A (the individual) would be treated as the shareholder. In short, the IRS was able to impose a kind of “heads I win, tails you lose” tax treatment. The “loss” would not be of significant use to the IRA (because of its tax exempt status) and the “gain” would be attributable to taxable individual (A)!

Significance:

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