PLR 202552008: Inadvertent S Corp Election Failure

Partnership Ownership Voids S Election

An attempted S Corporation election by an entity (X) with an ineligible shareholder – specifically, a multi-member LLC taxed as a partnership – initially failed, but the IRS granted relief under Section 1362(f) of the Internal Revenue Code, allowing the corporation to be treated as a valid S Corp from its original election date because the error was deemed 'inadvertent.' Section 1362(f) provides a mechanism for corporations to maintain S Corp status despite failing to meet all eligibility requirements, provided the failure was unintentional and corrected promptly.

The LLC Error: Timeline of Events

The Private Letter Ruling (PLR) details a specific timeline of events leading to the inadvertent S Corp election error. The corporation, identified as "X," was incorporated under state law on Date 1. Subsequently, X elected to be treated as an S corporation, with the election to take effect on Date 2. However, on Date 2, a shareholder, "A," was a multi-member limited liability company (LLC) that was classified as a partnership for federal tax purposes. Because partnerships are ineligible shareholders under Section 1361(b)(1)(B) of the Internal Revenue Code, which defines the permissible shareholders for an S corporation, X's S election was initially ineffective. The IRS consistently interprets this rule strictly: Partnerships cannot own S Corp stock.

To rectify this, on Date 3, A distributed its entire interest in X to a trust, an eligible S corporation shareholder. X represented to the IRS that the circumstances causing the ineffective S corporation election were inadvertent and not motivated by tax avoidance or retroactive tax planning.

Statutory Path to Forgiveness

As mentioned previously, due to the partnership ownership, X's S election was initially ineffective. The IRS consistently interprets this rule strictly: Partnerships cannot own S Corp stock.

To rectify this, on Date 3, A distributed its entire interest in X to a trust, an eligible S corporation shareholder. X represented to the IRS that the circumstances causing the ineffective S corporation election were inadvertent and not motivated by tax avoidance or retroactive tax planning.

The IRS's power to forgive this stems from several key sections of the tax code. Section 1361(b)(1)(B) defines the permissible shareholders for an S corporation. It states that S corporations cannot have partnerships or most other non-individuals as shareholders. Because X had a partnership as a shareholder, it violated this rule, invalidating the S election.

However, Section 1362(f), titled "Inadvertent Invalid Elections," provides a remedy. This section states that if a corporation's S election was ineffective because it failed to meet the requirements of Section 1361(b) regarding eligible shareholders, the IRS can still treat the corporation as an S corporation if the failure was inadvertent, the corporation took steps to correct the problem within a reasonable time after discovering it, and the corporation and its shareholders agree to make any necessary adjustments to reflect S corporation status.

The IRS concluded that because the ownership of shares by the partnership was inadvertent, and because X took steps to fix the problem by transferring the shares to a trust, X will be treated as an S corporation retroactively to Date 2.

Implications: The Importance of Vetting Shareholders

This case underscores the critical importance of carefully vetting potential shareholders before making an S corporation election. Internal Revenue Code Section 1361(b)(1)(B) states that a small business corporation cannot have a partnership or a multi-member LLC taxed as a partnership as a shareholder. While Section 1362(f), which provides relief for inadvertent invalid S elections, offers a potential remedy, obtaining a Private Letter Ruling (PLR) from the IRS is a costly and time-consuming process. As of February 1, 2025, the user fee for a PLR under Section 1362(f) is $43,700. Tax professionals should advise clients that strict adherence to shareholder eligibility rules is paramount to avoid these complications. This ruling, while favorable to the taxpayer in this instance, serves as a reminder that such rulings are directed only to the taxpayer who requested it and, pursuant to Section 6110(k)(3), may not be used or cited as precedent.