In Private Letter Ruling 201730002 we find a situation where a taxpayer’s death instantly terminated the S corporation in which he owned a 100% interest. The structure he created to hold the S corporation stock set up a situation in which the S election’s validity continued only so long as the shareholder remained alive.
Initially the taxpayer formed an S corporation in which he held a 100% interest. The taxpayer next took the following step:
On Date 2, A, the sole shareholder of X, transferred A’s entire interest in X to Y, a limited liability company wholly owned by A and treated as a disregarded entity for federal tax purposes.
Since the entity was disregarded, the stock was still treated as held directly by A. Since he was an eligible S corporation shareholder there was no problem.
Next, the taxpayer modified the structure one more time. The ruling describes the next step as follows:
On Date 3, A transferred a n% interest in Y to Trust, a grantor trust that was treated (under subpart E of part I of subchapter J of chapter 1) as entirely owned by A. Trust was an eligible shareholder under §1361(c)(2)(A)(i).
While a partnership is not an eligible S corporation, this LLC was not treated as a partnership for tax purposes because it didn’t have two different partners in the view of the Internal Revenue Code. A portion of the interest was held directly by A, while the remainder was deemed held by A under the grantor trust rules. Since you must have partners (plural) to have a partnership, the partnership didn’t exist since it was treated as entirely owned by one person. Thus, we still have an S corporation.
But now the terminating event arises. As the ruling describes:
On Date 4, A died, causing Trust to cease being a grantor trust.
Now we do have two partners—and therefore instantly the LLC converts to partnership status under the check the box rules, terminating the S election.
Note that the trust in question, being previously treated as a 100% grantor trust of one person, would have qualified to hold the S shares for two years after the date of death. As well, A’s estate was an eligible S shareholder. The problem was having those two entities hold the shares in a partnership structure—or, more appropriately, what became such a structure for tax purposes.
The corporation did apply for and receive relief from the IRS—but at the cost of having to pay the user fee to obtain a private letter ruling.
The key lesson in this case is to note the fragility of the S corporation structure—it is very easy to terminate the status, sometimes in ways that aren’t immediately obvious. We don’t know why the structure in question was chosen, but clearly having one LLC whose interests were divided between two entities created, even though the structure caused no immediate problem with the continued qualification for S status for the corporation.