An inadvertent termination of a company's S corporation status can mess up even the
best tax planning intentions. Here are some important considerations and suggestions
to help avoid an inadvertent loss of the company's qualification to be treated as an
100-shareholder limitation. The S election will terminate if the
number of S corporation shareholders is more than 100 at any time during any year.
Therefore, it is important to monitor future stock issues so that the 100-shareholder
limitation will not be exceeded. A shareholder agreement can help avoid termination
of the S election by prohibiting the transfer of shares that would result in more
than 100 shareholders.
Ineligible shareholders. An S corporation can generally have only
shareholders that are (1) individuals who are U.S. citizens or residents,
(2) estates, and (3) certain types of trusts. Ineligible shareholders include
nonresident aliens, partnerships, corporations, and nonqualified trusts. Therefore,
it is important to continually ensure that all the shareholders are eligible to hold
S corporation stock.
A shareholder agreement is one of the most important tools available to protect the
corporation's S election from termination because shares have been transferred to an
ineligible shareholder. Such an agreement should prohibit the transfer of any shares
to a person other than a permitted S corporation shareholder.
One class of stock. An S corporation can have only one class of
stock. This means that all outstanding shares must confer identical rights to
distribution and liquidation proceeds. The rules do provide, however, that an S
corporation can issue both voting and nonvoting stock without violating the
one-class-of-stock rule. This rule is complicated, so be sure to contact us when
considering future changes to the capital structure of the corporation or when
drafting agreements that may affect distribution and liquidation rights.
Excess passive investment income. If a corporation has more than 25%
of its gross receipts from passive investment sources in three consecutive years and
has C corporation Accumulated Earnings and Profits (AE&P) at the end of each year,
then S status is terminated as of the beginning of the fourth consecutive year. An S
corporation will generally have AE&P only if it previously operated as a C
corporation or acquires a C corporation in a tax-free reorganization.
Corporate records tracking the corporation's passive investment income should be
maintained to determine whether the 25% limitation will be exceeded. If a corporation
is in danger of going over the 25% passive income limitation for three consecutive
years, termination of the corporation's S status can be avoided by distributing the
AE&P to shareholders. Furthermore, if the corporation lacks the cash or liquid assets
to make the distributions, the corporation can elect to make a "deemed" dividend. If
such an election is made, the corporation acts as though a distribution has been (1)
paid to the shareholders and (2) contributed back to the corporation. Any
distribution of AE&P, however, whether actual or deemed, is taxable to shareholders
as a dividend.
If distributing the AE&P is not feasible, it may be possible to avoid termination
under the passive income rules by arranging the corporation's operations so that the
25% passive income limit is not exceeded for three consecutive years. To accomplish
this, the corporation could (1) reduce the amount of passive investment income, (2)
increase the amount of other income, or (3) do a combination of both.
Let us help. These rules are complex, and some of the procedures
apply only if special tax elections are properly filed with the IRS. If you have any
questions or if you are considering implementing any of these procedures, please do
not hesitate to contact us.
This publication is distributed with the understanding that the author, publisher and
distributor are not rendering legal, accounting or other professional advice or
opinions on specific facts or matters, and, accordingly, assume no liability
whatsoever in connection with its use. The information contained in this newsletter
was not intended or written to be used and cannot be used for the purpose of (1)
avoiding tax-related penalties prescribed by the Internal Revenue Code or (2)
promoting or marketing any tax-related matter addressed herein. © 2015