Inadvertent terminations of S and QSub elections

By Hoornaz Mostofizadeh, CPA, Irvine, Calif.

Editor: Mark G. Cook, CPA, CGMA

In IRS Letter Ruling 202219005, released May 13, 2022, the Service addressed a consolidated corporation’s request to apply Sec. 1362(f ) to provide relief from termination of the corporation’s subsidiary’s S corporation and qualified Subchapter S subsidiary (QSub) elections.


On date 1, a parent company (X) formed a subsidiary (Sub) as a limited liability company in state 1, and Sub elected to be treated as a partnership for federal income tax purposes. Sub’s operating agreement included partnership provisions that applied regardless of whether X was a partnership. On date 2, Sub made an S corporation election; however, due to Sub’s operating agreement having allowed disproportionate distribution and liquidation proceeds, the election became ineffective under Sec. 1362(b)(1)(D). Sub requested relief from a termination of its S election under Sec. 1362(f) due to having more than one class of stock.

On date 3, Sub’s shareholders formed X in state 2, and on date 4, Sub made X a wholly owned subsidiary of Sub by contributing all the stock in Sub to X in a purported reorganization under Sec. 368(a)(1)(F). This would have resulted in X’s being treated as the successor S corporation to Sub for federal tax purposes without having to make a new S election, pursuant to Rev. Rul. 2008-18. Since Sub’s original S election was ineffective, Sub became a disregarded entity for federal income tax purposes. X therefore made an S corporation election, effective on date 3.

On date 4, X filed an election to treat Sub as a QSub, but the election was ineffective because Sub was not a corporation as defined by Regs. Sec. 301.7701-2(b). Therefore, X had failed because it did not meet all the requirements of Sec. 1361(b)(3)(B). On date 5, X sold some of its interest in Sub to a third party.

From date 2 to date 4, all distributions and liquidation proceeds were identical, and the shareholders and Sub had consistently filed tax returns as an S corporation. Moreover, Sub did not change the agreement’s provisions despite not being an S corporation. Further, X stated that the circumstances that led to both the S corporation and QSub elections’ becoming ineffective were inadvertent, not the result of tax avoidance or retroactive tax planning. In the ruling request, the shareholders and Sub agreed to any required adjustments by the IRS under Sec. 1362(f ) consistent with the treatment of Sub on date 2 as an S corporation and on date 4 as a QSub.

Legal principles

Sec. 1361(b)(2) provides that financial institutions that use the reserve method for bad debts, taxable insurance companies, or domestic international sales corporations (DISCs) or former DISCs are ineligible to be a small business corporation under Subchapter S. Under Sec. 1361(b)(1), a small business corporation is a domestic corporation that is not ineligible and does not have more than 100 shareholders. Further, under Sec. 1361(c) (2), allowable shareholders are individuals, certain trusts and estates, or organizations defined under Sec. 1361(c)(6), none of which may be nonresident aliens. Finally, an S corporation may have only one class of stock.

Sec. 1361(a)(1) defines an S corporation as a small business corporation whose election is effective in any tax year and for which all shareholders agree to such an election on the day of the election (Sec. 1362(a)).

Sec. 1361(b)(3)(A) states that a QSub shall not be treated as a corporation separate from an S corporation. All its assets, liabilities, income, deductions, and credits are treated as items of the S corporation unless the IRS provides otherwise in regulations.

Sec. 1361(b)(3)(B) defines a QSub as a domestic corporation that is not ineligible and is wholly owned by the S corporation, which elects to treat the subsidiary as a QSub. In addition, Regs. Sec. 1.1361-3(a)(1) states that the corporation that made the QSub election shall meet all the conditions of Sec. 1361(b)(3)(B) at the time of the election and during the effective periods of the election.

Regs. Secs. 1.1361-1(l)(1) and (4) state that a corporation with more than one class of stock is not qualified as a small corporation unless all outstanding shares of stock confer identical rights to liquidation and distribution proceeds.

Regs. Sec. 1.1361-1(l)(2)(i) states that “the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements” define whether all outstanding shares of stock confer identical rights to liquidation and distribution proceeds. Even though a corporation is treated as having one class of stock, as long as the governing provisions determine identical rights to distributional and liquidation proceeds, any distribution that varies in timing or amount is treated with appropriate tax effect.

Sec. 1362(f) states that the IRS may determine whether the circumstances leading to termination or ineffectiveness of the elections were inadvertent, if a corporation takes steps within a reasonable time after discovering the circumstances to qualify as an S corporation, including by acquiring required shareholder consents. In addition, all shareholders of the corporation during the period of termination or ineffectiveness of the S election must agree to adjustments consistent with treatment of the corporation as an S corporation or QSub under Sec. 1362(f) or as determined by the IRS.

The IRS’s conclusion

The IRS concluded in Letter Ruling 202219005 that Sub’s S election was ineffective on date 2, due to having more than one class of stock, according to the operating agreement. However, the circumstances causing the termination of the S election were inadvertent within the meaning of Sec. 1362(f), the IRS ruled. Thus, the letter ruled, Sub was treated as an S corporation from date 2 to date 4, as long as its S election was otherwise valid and not terminated under Sec. 1362(d).

Further, the IRS concluded that the QSub election was ineffective on date 4; however, the IRS decided that the circumstances leading to the termination of the QSub election also were inadvertent under Sec. 1362(f). Therefore, X’s election to treat Sub as a QSub was treated as effective from date 4 to date 5. The IRS noted that this ruling applies to the taxpayer only and cannot be used as precedent.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or Contributors are members of or associated with SingerLewak LLP.

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