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is a domestic corporation that is not in- Sec. 1362(f) states that the IRS may July 14, 2022, to provide its interpreta-
eligible and does not have more than 100 determine whether the circumstances tion of the sourcing of Sec. 751(a) gain
shareholders. Further, under Sec. 1361(c) leading to termination or ineffectiveness from the disposition of a nonresident
(2), allowable shareholders are individuals, of the elections were inadvertent, if a cor- individual’s partnership interest to the
certain trusts and estates, or organizations poration takes steps within a reasonable extent the Sec. 751 property is located in
defined under Sec. 1361(c)(6), none of time after discovering the circumstances California, pursuant to Cal. Code Regs.
which may be nonresident aliens. Finally, to qualify as an S corporation, including tit. 18, Section 17951-4.
an S corporation may have only one class by acquiring required shareholder con-
of stock. sents. In addition, all shareholders of the Overview
Sec. 1361(a)(1) defines an S corpora- corporation during the period of termina- In its ruling, the FTB addresses two
tion as a small business corporation tion or ineffectiveness of the S election situations. In Situation 1, a nonresident
whose election is effective in any tax year must agree to adjustments consistent individual partner owns a 49% interest
and for which all shareholders agree to with treatment of the corporation as an S in a partnership that carries on business
such an election on the day of the elec- corporation or QSub under Sec. 1362(f) wholly within California that has assets
tion (Sec. 1362(a)). or as determined by the IRS. including unrealized receivables, appreci-
Sec. 1361(b)(3)(A) states that a QSub ated inventory located in California, and
shall not be treated as a corporation sepa- The IRS’s conclusion depreciation recapture assets also located
rate from an S corporation. All its assets, The IRS concluded in Letter Ruling in California (also referred to as “hot
liabilities, income, deductions, and credits 202219005 that Sub’s S election was assets”). The partner sells its partnership
are treated as items of the S corpora- ineffective on date 2, due to having more interest to an unrelated third party. Situa-
tion unless the IRS provides otherwise than one class of stock, according to tion 2 assumes the same facts, except that
in regulations. the operating agreement. However, the the partnership conducts business within
Sec. 1361(b)(3)(B) defines a QSub circumstances causing the termination of and without California.
as a domestic corporation that is not the S election were inadvertent within the For Situation 1, the ruling holds
ineligible and is wholly owned by the S meaning of Sec. 1362(f), the IRS ruled. that all gain or loss associated with the
corporation, which elects to treat the sub- Thus, the letter ruled, Sub was treated as partnership’s Sec. 751 property is sourced
sidiary as a QSub. In addition, Regs. Sec. an S corporation from date 2 to date 4, as to California. Cal. Code Regs. tit. 18,
1.1361-3(a)(1) states that the corporation long as its S election was otherwise valid Section 17951-4(a), provides that net
that made the QSub election shall meet and not terminated under Sec. 1362(d). income from a nonresident’s business,
all the conditions of Sec. 1361(b)(3)(B) Further, the IRS concluded that the trade, or profession carried on wholly
at the time of the election and during the QSub election was ineffective on date within California is California-source
effective periods of the election. 4; however, the IRS decided that the income. Because the business is con-
Regs. Secs. 1.1361-1(l)(1) and (4) circumstances leading to the termination ducted wholly within California and
state that a corporation with more than of the QSub election also were inad- the FTB deems this in part a sale by the
one class of stock is not qualified as a vertent under Sec. 1362(f). Therefore, partnership (discussed further below), all
small corporation unless all outstanding X’s election to treat Sub as a QSub was of the partner’s income attributed to the
shares of stock confer identical rights to treated as effective from date 4 to date 5. Sec. 751 gain or loss will be sourced to
liquidation and distribution proceeds. The IRS noted that this ruling applies California. The partner’s Sec. 741 gain is
Regs. Sec. 1.1361-1(l)(2)(i) states that to the taxpayer only and cannot be used considered the sale of intangible property
“the corporate charter, articles of incor- as precedent. and sourced pursuant to Cal. Rev. & Tax.
poration, bylaws, applicable state law, and From Hoornaz Mostofizadeh, CPA, Code (RTC) Section 17952. Assuming
binding agreements” define whether all Irvine, Calif. the intangible asset has not otherwise
outstanding shares of stock confer identi- established a business situs in California,
cal rights to liquidation and distribution the Sec. 741 gain would not be sourced
proceeds. Even though a corporation is State & Local Taxes to California.
treated as having one class of stock, as For Situation 2, the ruling holds that
long as the governing provisions deter- Sourcing Sec. 751(a) gain from gain or loss associated with the partner-
mine identical rights to distributional and nonresident’s sale of California ship’s Sec. 751 property is sourced to
liquidation proceeds, any distribution that partnership interest California, based upon the partnership’s
varies in timing or amount is treated with The California Franchise Tax Board California apportionment factors by
appropriate tax effect. (FTB) issued Legal Ruling 2022-02 on operation of Cal. Code Regs. tit. 18,

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