Keep an Eye on S Corp. Eligibility Rules

Winter 2008

Business owners often choose S corporation status to eliminate the double taxation of profits that would occur with a C corporation election. One of the basic eligibility requirements for S corporation status is that only eligible shareholders can be owners.

S corporations are usually owned by a few individual shareholders, so the question of eligible shareholders is often not difficult. However, with more sophisticated business and tax planning, the likelihood is greater that an ineligible shareholder could become an owner of S corporation shares. Shareholder eligibility is an area where practitioners must take great care, since an ineligible shareholder will terminate the S corporation election.

Internal Revenue Code (IRC) §1361(b)(1)(C) states that nonresident aliens cannot be shareholders of an S corporation, and precludes foreign trusts from being S corporation shareholders. The following types of trusts are permitted to be S corporation shareholders:

• Trusts treated as owned by a U.S. citizen or individual under the grantor trust rules (IRC §671-679). Care must be taken to make sure nonresident individuals are not involved, and that the single-deemed owner rule is considered.
• Trusts to which stock was transferred through a will, but only for two years from the date the stock is received by the testamentary trust.
• Voting trusts created to exercise the voting power of stock transferred to it may be a shareholder. Each beneficiary of the voting trust is treated as one shareholder of the S corporation.
• Qualified Subchapter S Trust (QSST). QSSTs require that, during the life of the current income beneficiary, there can be only one income beneficiary. The beneficiary’s income interest must terminate on the earliest of either the beneficiary’s death or termination of the trust.
• Electing Small Business Trusts (ESBT). The ESBT can have multiple beneficiaries, and trust income can be accumulated and sprinkled among multiple beneficiaries. A trust must elect to be treated as an ESBT, which is made by the trustee. The ESBT is treated as two separate trusts for tax liability purposes: the S portion and the non-S portion.
• Estates.
• Exempt organizations, as described in §401(a) and §501(c)(3).

Shareholder eligibility matters must be considered when dealing with other business aspects of S corporation ownership, such as stock transfers. For example, if a buy/sell agreement is in place, it must be structured so ineligible shareholders cannot purchase S corporation shares, or the S election is terminated.

Gifting S corporation shares can have significant tax advantages, but you must ensure that the donee is not an ineligible shareholder. The same care must be given during estate planning. Designated beneficiaries must be carefully considered. Buy/sell arrangements also should be tightly drawn to manage S corporation restrictions and prevent transfers to ineligible shareholders.

When a practitioner is involved in more sophisticated business and tax planning with regard to S corporation shares, consideration must be given to the strict rules regarding the eligibility of shareholders. An ineligible shareholder can have disastrous consequences for the S corporation and its shareholders.

Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.

Carol G. Murray, CPA, JD, is an associate with Metz Lewis. She can be reached at cmurray@metzlewis.com.

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