Preventing a Dissident Shareholder from Transferring Stock to Cause a Loss of S Status

When a corporation first elects S status, all shareholders of the corporation must consent to the election (Sec. 1362(a)(2)). However, once S status is in place, new shareholders, whether acquiring stock by purchase or gift, need not consent to the election, nor are they given the opportunity to consent.A voluntary revocation of S status can occur only when shareholders owning more than 50% of the corporation’s stock consent in writing to a termination of S status (Sec. 1362(d)(1)).

A corporation can also lose its S status by ceasing to meet the eligibility requirements for S corporations (Secs. 1362(d)(2) and 1361(b)(1)). Most of the eligibility requirements are within the corporation’s control and could not be influenced by one or two dissident minority shareholders (for example, creating a second class of corporate stock, earning excessive passive income, conducting business as an insurance company, etc.).However, one major criterion for S corporation eligibility is within the control of a minority shareholder: the requirement that an S corporation not have as a shareholder a person other than an individual (other than a nonresident alien), estate, or certain trusts (Sec. 1361(b)(1)(B)).

A minority shareholder can unilaterally cause the termination of S status for the corporation by transferring one or more shares to an ineligible shareholder. Examples include a transfer of S corporation stock to a corporation, a nonqualifying trust, or a nonresident alien.

If a dissident minority shareholder should transfer stock to an ineligible holder, the corporation might attempt to argue that beneficial ownership of the stock had not actually transferred to the ineligible recipient if the facts indicate that the new owner had not assumed full control of the stock. Under prior S corporation rules (in an era when a new shareholder’s consent to S status was required), it was not unusual to attempt a termination of S status by transferring one share to a party who would decline to consent to the S status.

The courts have on several occasions held that a nominal transfer, when the new owner did not assume full economic control and ownership of the stock, would be disregarded for termination purposes. The courts used a facts-and-circumstances test to scrutinize the economic reality of stock transfers, viewing such matters as the consideration paid for the transfer of the shares, the degree of control exercised by the new owner, etc. In Hook, 58 TC 267 (1972), the court held that the transfer of S corporation stock to the shareholder’s attorney was not bona fide and lacked economic reality, so the attorney’s failure to consent to the corporation’s S election did not terminate its S status under prior law. Similarly, in Auld, TC Memo 1978-508, the court held that the son, to whom the S shareholder transferred a portion of his S corporation stock, was not the beneficial owner ofthe stock, so the son’s failure to consent to the corporation’s S election did not terminate its S status under prior law.

Whenever even a single share of stock is transferred to an ineligible holder in a bona fide transfer, the courts will support the termination of S status (see T. J. Henry Associates, Inc., 80 TC 886 (1983)). However, when the S shareholders were found to have a fiduciary duty under (Massachusetts) state law not to act in a way that would cause the S corporation to lose the considerable benefits of S status, the court permanently enjoined a shareholder from transferring a portion of his S stock to an ineligible shareholder (A. W. Chesterton Co. v. Chesterton, 128 F3d 1 (1st Cir. 1997)).

Example: Tyler Corp. is an S corporation owned by three brothers.The corporation has been very successful, and the brothers anticipate that in about 10 years they will retire and sell the corporate assets and business activities. They would like to begin making gifts of stock to their adult children. However, some of the children have questioned the business affairs and management of the corporation, and the brothers are concerned that these children may not recognize the importance of S status. How can the brothers preserve the corporation’s S election?

A voluntary revocation of S status can occur only when shareholders owning more than 50% of the corporation’s stock consent in writing to S status termination (Sec. 1362(d)(1); Regs. Sec. 1.1362-6(a)(3)). Thus, if the three brothers retain at least 50% of the stock of Tyler Corp., a voluntary revocation by the other shareholders is not possible.

However, one or more of the Tyler children could easily terminate the corporation’s S status by forming a C corporation to hold one or more shares of their stock or by forming a complex trust to act as a shareholder. Because these are ineligible shareholders, such a transfer of stock would cause S status termination, effective on the date of transfer (Sec. 1362(d)(2)).

A shareholder agreement should be created to prevent any transfer of stock by any shareholder to an ineligible holder before any gifts or sales of stock to the children occur. Additional strategies that might minimize the risks of having the children as shareholders include:

1. The stock issued to the children could be limited to nonvoting shares.

2. If the corporation, as an S corporation, generates passthrough taxable income but no distributable cash flow, the corporation could borrow and distribute a sufficient amount to cover the shareholders’ personal tax liabilities.

To summarize, if a dissident shareholder wishes to cause termination of the corporation’s S status, the bona fide transfer of even a single share to an ineligible holder will cause termination. To prevent this, the shareholders should create a shareholder agreement or a buy/sell agreement that restricts the shareholders’ ability to transfer stock to outsiders.

Using a Shareholder Agreement to Prevent Stock Transfer

A shareholder agreement can be used to prevent any stock transfer by any shareholder to an ineligible shareholder.This agreement might take the form of a buy/sell agreement, wherein any shareholder must first offer the stock to the corporation and to the other existing shareholders before any transfer can be made to outside parties. To further solidify such an arrangement, the stock certificates can include a designation that the shares are subject to a restrictive agreement and may not be transferred other than under the terms of this restrictive agreement.

Two additional issues must be addressed when using a shareholder buy/sell agreement. First, assuming the shareholder agreement attempts to value the shares transferred by the shareholders (rather than merely prohibiting the transfer of stock to an ineligible S corporation shareholder), the agreement must comply with the estate-freeze provisions of the Code. Under Sec. 2703(a), the value of property, including stock, is determined without regard to (1) an option, agreement, or other right to acquire the property for less than fair market value (FMV) or (2) any restriction on the right to sell or use the property.

However, an exception applies to any agreement, right, or restriction that:

1. Is a bona fide business arrangement;

2. Is not a device to transfer property to a transferor’s family member for less than full and adequate consideration; and

3. Includes terms that are comparable to “similar arrangements entered into by persons in an arm’s length transaction” (Sec. 2703(b); Regs. Sec. 25.2703-1(b)(1)).

While maintenance of family ownership and control of the business can provide the agreement with a “bona fide business purpose,” the existence of a valid business purpose does not necessarily mean that the agreement is not a tax-avoidance device. Nevertheless, stating that the express purpose of the agreement is to protect the corporation’s S election should provide substantial proof that it was entered into for legitimate business reasons.

The third requirement in the preceding list contemplates proof that the right or restriction in the agreement is comparable to what could have been obtained in a fair bargain among unrelated parties in the same type ofbusiness.This determination involves consideration of the expected term of the agreement, the stock’s current market value, anticipated changes in the stock’s value during the term of the agreement, and any consideration given in return for the rights granted by the agreement. A right or restriction is considered to be a fair bargain among unrelated parties in the same type ofbusiness ifit conforms with general business practice (Regs. Sec. 25.2703-1(b)(4)(ii)).

The second issue that must be addressed when using a shareholder buy/sell agreement is to ensure that the agreement complies with the one-class-of-stock rules.The regulations state that a shareholder buy/sell agreement will, in general, be disregarded unless a principal purpose of the agreement is to circumvent the one-class-of-stock requirement and the agreement establishes a purchase price (at the time the agreement is entered into) that is significantly in excess of or below the stock’s FMV.

A safe harbor is provided for agreements that establish a purchase price between the stock’s book value and its FMV. The IRS must respect a good-faith determination of FMV unless the value is substantially in error or was not determined with reasonable diligence (Regs. Sec. 1.1361-1(l)(2)(iii)(A)). The regulations also include a safe harbor for the determination of a stock’s book value. A determination of book value will be respected if computed in accordance with GAAP or ifused for any substantial nontax purpose (Regs. Sec. 1.1361-1(l)(2)(iii)(C)).

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 21st Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).