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:

Note that this ruling does not address the income tax consequences of the distribution of the S stock from the IRA. (If shareholder A was under age 59½, there may also be a 10 % penalty tax.) The PLR simply addresses the issue of the inadvertent termination.

Many clients’ closely held businesses have elected S status. Preserving the S status is often a valuable income tax attribute. As clients engage in estate planning strategies (both during life and at death), it important to focus on what entities (trusts, etc) are permissible shareholders and making sure shareholder consent is acquired on a timely basis. If S status is lost, the general rule is the corporation cannot re-elect S status for 5 years.

As a complement to the estate planning process, S corporations frequently do purchase life insurance for a variety of needs such as:

• Buy/sell agreements (cross purchase or stock redemption)
• Collateral for debt obligations
• Executive benefit programs
• Key person protection

*Private Letter Rulings/TAMs are directed only to the taxpayer on whose behalf it was requested. Section 6110(k)(3) of the Internal Revenue Code provides that it may not be used or cited as precedent.

DEFINITIONS OF TERMS

An S corporation is a corporation that is created under state law like any other corporation. After incorporation, the new corporation elects S status by filing Form 2523 with the IRS on a timely basis. Unlike a “regular” C corporation, an S corporation has different tax attributes. In a regular C corporation, the entity itself is taxable. In an S corporation, all items of income and deduction flow through to the shareholders.