Did You Know?
By: THOMAS W. GARTON
December 2007
An article in a series containing reminders about tax traps for the unwary and information about new or developing income tax rules.
Police the State of Your S Election
With up to ten years of comfortable S corporation operations under their belts, banks and holding companies should guard against complacency. The goal is to avoid inadvertent termination of the S election. Perhaps the most fragile and vulnerable qualification requirements are those prescribing who are qualifying shareholders.
The general rule is pretty simple. Only U.S. resident individuals, certain estates, and certain trusts may be shareholders. Once the original shareholders are established and the S election is made, it is critical to preserve that status. Buy Sell Agreements are the front line of defense. Among other purposes, these agreements generally restrict transfer of shares to any holder whose ownership would cause the S election to terminate. If a transfer is sought by an existing shareholder, the corporation will want assurances that the transferee is a qualifying shareholder.
As mentioned above, certain trusts can be S corporation shareholders. There are three primary categories of trusts (in addition to certain tax exempt trusts) that qualify. They are grantor trusts, Electing Small Business Trusts (“ESBTs”), and Qualified Subchapter S Trusts (“QSSTs”). Without going into the sometimes esoteric definitions, it is important to note that in order for a trust to qualify as an ESBT or as a QSST, the trustee (in the case of an ESBT) or the beneficiary (in the case of a QSST) must make certain tax elections to qualify. Whenever either of these trusts intends to become a shareholder, the corporation should obtain confirmation that the appropriate election has been made. Failure to elect is fatal to the S election of the corporation, but the election is not within the control of the corporation.
Even after a trust has been established to qualify under one of the categories of acceptable trusts, there is a possibility that future events can create problems. The Buy Sell Agreement will prevent inadvertent transfer of the shares to nonqualifying shareholders. But where the problematic event is not a stock transfer, the corporation may not become aware until it is too late. The problem can arise when a trust, say a grantor trust, is amended so that it no longer qualifies as a grantor trust. Even if the amendment results in terms that would allow the trust to qualify as an ESBT or a QSST, without the required tax election, the trust becomes a disqualifying shareholder.
S Corporations would be well advised to retain copies of the trust instruments relating to their shareholders. Further, though it is seldom done, the corporation could require notification before any change in the trust is made by requiring the trustee of the shareholder trust to notify the corporation of any change in the trust instrument. This is not a fail safe solution, but it goes a long way to policing the characteristics of shareholders that are trusts.
Takeaway
If a disqualifying change does occur inadvertently, all is not lost. The IRS is fairly flexible in allowing a corporation to “cure” an inadvertent termination. It is likely that this dispensation will be more readily available if the corporation has been diligent in its efforts to preserve the election, and if the event was not within its control.