Momentary ownership does not terminate S election

The IRS released a ruling (IRS PLR 202506003) on whether an S election terminates under Section 1362(d)(2) for instances when an ineligible S corporation shareholder momentarily owns shares of an S corporation, but  the momentary ownership is insignificant and transitory.

In the private letter ruling the S corporation had an equity compensation plan that allowed the interest of the S corporation to be transferred by either the S corporation or the majority shareholder to employees, service providers, or subsidiaries. Both the S corporation and the majority shareholder had the ability to also assign their repurchase rights under the equity compensation plan. The S corporation later had a restructuring, and the newly created parent company was also covered under the compensation plan. After the restructuring, the transfer of interest under the equity compensation plan by the S corporation and the majority shareholder to employees, service providers, or affiliated entities caused momentary ownership of the S corporation by the affiliates. Some entities that momentarily owned the stock were ineligible to be S corporation shareholders. The letter does not go into specific details about the structure of the entities, but it notes that the position of these entities in the structure caused some ineligible S corporation shareholders to momentarily own the S corporation stock.

Under the principles of IRC Sections 1361(b)(1) and 1362(d)(2), if an ineligible shareholder owns the stock of an S corporation, the S election terminates on the date the ineligible shareholder receives the stock and the S corporation stops being a “small business corporation.” As it relates to equity compensation plans, under Treas. Reg. Section 1.83-6(d)(1), a transfer of property by a shareholder of an employer to a service provider or employee as payment for services is treated as a capital contribution by the shareholder to the corporation and then a transfer from the corporation to the service provider of such property.

This section references Treas. Reg. Section 1.1032-3 for situations in which a corporation transfers its own shares as compensation to someone who provides services to another corporation or partnership. Where Treas. Reg. Section 1.1032-3 applies, it allows the purchase of property by a subsidiary using parent stock to be treated in the same manner as that property purchase by the parent using its own stock, followed by the parent transferring the property to its subsidiary. The subsidiary gets a cost basis in the parent stock immediately before using it to purchase property or compensate a service provider and the subsidiary does not recognize gain on the transfer of the parent stock.

The IRS determined in the letter that, despite the application of the rules of Treas. Reg. Sections 1.83-6(d)(1) and 1.1032-3, solely for purposes of Section 1361, the momentary ownership by ineligible shareholders would not terminate the S election under Section 1362(d)(2). This is because the rules of Treas. Reg. Sections 1.83-6(d)(1) and 1.1032-3 were created to solve timing and basis concerns and were not intended to impact S election status. 

While the IRS provides a favorable determination for the taxpayer, the letter does not provide a generally applicable rule that other taxpayers can apply without receiving their own PLR. Additionally, the IRS noted that the organization’s structure allowed these transfers to cause momentary ownership but did not expound on the specifics of the structure. Without more details on the specifics of the structure, the IRS could determine a different structure does still terminate the S election.  We would expect that taxpayers experiencing a similar issue as described in this ruling would likely have to request their own private letter ruling for relief. 

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