Momentary ownership does not terminate S corp elections

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The IRS this month released a ruling (IRS PLR 202612005 (PDF - 116.89KB)) that momentary ownership by a partnership in two S corporations, due to transfers of stock pursuant to equity compensation plans of the S corporations, did not result in the termination of the S corporation elections under Section 1362(d)(2) because the transactions were transitory.

In the private letter ruling, the taxpayer, entity X, was treated as an S corporation for federal income tax purposes and engaged in a reorganization intended to qualify as an F reorganization. The F reorganization consisted of X forming a new C corporation, entity Y and X shareholders exchanging their shares in the S corporation, X, for shares in Y corporation. The shareholders included both individuals and employees of X.

Corporation Y then filed Form 8869, Qualified Subchapter S Subsidiary (QSub) Election, to treat X as a QSub for federal tax income purposes and succeeded to the S election of X. X then converted to a limited liability company. Thereafter, entity Z was formed and elected to be treated as an S corporation from formation. The shareholders of Z consist of individuals and certain employees of X. Subsequently, Z acquired an interest in X, and X was treated as a partnership for federal income tax purposes henceforth.

Both Y and Z adopted equity compensation plans giving rights to employees to purchase shares, including employees of X. Pursuant to these plans, X provided cash to Y and Z for the shares Y and Z issued under the equity compensation plans to X employees, as compensation for services provided to X. These compensation transactions caused X to be deemed a momentary owner of Y and Z stock.

Generally, Treas. Reg. Section 1.83-6(d)(1) provides that 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 cross references Treas. Reg. Section 1.1032-3, which discusses the characterization of a corporation transferring its own shares as compensation to someone who provides services to another corporation or partnership.

Treas. Reg. Section 1.1032-3 treats the transaction as a deemed contribution of cash from parent to subsidiary and then, immediately after, a deemed purchase of stock of the parent by the subsidiary with the deemed contributed cash.

Regarding termination of the S corporation election, Sections 1361 and 1362 prescribe that partnerships are ineligible shareholders of an S corporation. Therefore, if an ineligible shareholder owns the stock of an S corporation, the S corporation terminates on the day on which the ineligible shareholder receives the stock.

In the ruling, the IRS concluded that the deemed transactions under these sections were created solely to solve timing and basis concerns and were not intended to impact S corporation election status. As a result, the momentary ownership of Y and Z stock by X, an ineligible S corporation shareholder — the result of transfers authorized under the equity compensation plans — was transitory, and the S corporation elections for Y and Z were not terminated under Section 1362(d)(2).

The IRS applied a similar analysis and conclusion in IRS PLR 202506003 (PDF - 89.43KB), in which an S corporation, through a compensation plan, provided S corporation stock to employees of related entities that were ineligible shareholders. The IRS determined that the deemed momentary transfer of S corporation stock to the ineligible related entities before the stock was provided to employees did not cause a termination of the S election because the transfers were insignificant and transitory.