- S corporations may be owned through a network of trusts, partnerships and LLCs when DEs are properly used.
- Letter Ruling 200439028 presents a variation on recent ownership schemes, with a layered structure involving DEs.
- The intertwining structure of complex ownership networks often leaves the S corporation’s eligibility status uncertain.
Recent statistics indicate that over 3 million S corporations filed returns for the 2003 tax year; the total is expected to exceed 3.5 million for 2004. S corporation filings exceed partnership filings by approximately 1 million; further, there are more new S corporations than new partnerships. Thus, the S corporation continues to deserve significant attention by tax planners and policy makers.
S corporations have some unique eligibility rules, such as the maximum number and eligible types of shareholders; further, the entity can issue only a single class of stock. This article discusses some recent structuring ideas to expand ownership, yet remain within the S corporation limits. Although the structures discussed may diversify the actual beneficial ownership, they do not alter the Federal income tax reporting of the corporation’s income and losses by the ultimate shareholder.
Several taxpayers have received letter rulings concerning complex situations in which S stock was owned by trusts, partnerships and limited liability companies (LLCs). Some of these ownership structures appear to violate the S corporation ownership rules. However, because some of the holders were treated as disregarded entities (DEs), the stock was nevertheless treated as being owned by an individual and the S election was safe. Even though the ownership patterns may be varied, tax professionals should exercise caution in recommending them. Taxpayers, and the tax advisers who put them into these complex ownership arrangements, may learn, to their dismay, that the S election is in serious jeopardy. Anything that alters the tax treatment of any of the entities involved (even the death of one of the parties) may endanger the corporation’s S election.
This article also reviews a recent ruling 3 in detail; it presents some significant potential problems that might exist when a grantor dies (or there is any other change of ownership), and suggests actions to take to save the S election.
Subchapter S was adopted in 1958 and materially amended in 1982. Throughout its entire history, rules have limited the number and types of shareholders. The original rules allowed only 10 shareholders at any one time, all of whom had to be individuals or estates. No form of trust could own stock in an S corporation (then known as an “electing small business corporation” or a “subchapter S corporation”); even voting trusts and grantor trusts were prohibited.
Over the years, the law was amended to permit additional shareholder types and greater numbers. Currently, under Sec. 1361(b)(1)(A), there may be up to 100 shareholders, with some rather generous family attribution rules under Sec. 1361(c)(1)(A)(ii). Five basic types of trusts are allowable shareholders, under Sec. 1361(c)(2):
1. A grantor (or deemed grantor) trust throughout the lifetime of the deemed owner and up to two years after his or her death;
2. A testamentary trust, for two years after it is funded;
3. A qualified subchapter S trust (QSST), for which the beneficiary has elected to be treated as the deemed owner of the S stock (there are rigid requirements);
4. An electing small business trust (ESBT), which pays tax on income flowing through from the corporation, regardless of any distributions to beneficiaries; and
5. A voting trust.
Beneficial vs. Nominal Ownership
A person may hold title to property as a guardian, a custodian or an agent for another. When this form of ownership applies to S stock, there may be a problem in determining if the stock is held by an eligible person. In the early years, the IRS focused on the form, rather than the substance.
Regs. Sec. 301.7701-3 (the “check-the-box” regulation) applies to all unincorporated organizations. In general, a domestic organization other than a corporation is not treated as a corporation unless it affirmatively elects such treatment. The regulation does not single out LLCs, but extends to all unincorporated businesses, including general partnerships, limited partnerships and limited liability partnerships.
The default tax status of a domestic entity is a partnership if it has more than one member, under Regs. Sec. 301.7701-3(b)(1)(i). If there is a single member, the entity is disregarded for Federal income tax purposes. At first blush, one might conclude that the only DEs defined in the regulation are LLCs, because it is impossible to have a one-person partnership. However, the disconnect between the business association statutes and the Federal tax classifications has led to some partnerships being treated as DEs for Federal tax purposes. 4 Thus, it is possible to have a partnership between two or more persons or entities for state law purposes, but only one person (and an entity) for Federal income tax purposes. Examples include an individual and his or her grantor trust, an individual and a single-member LLC (SMLLC) owned by that individual, etc.
The IRS has ruled that an SMLLC can hold stocks, if the LLC owner is eligible and there is no election to treat the LLC as a corporation for Federal income tax purposes. 5 It has further ruled that a partnership between an SMLLC and its owner was also a DE and, thus, eligible to hold S stock. 6 In another approved pattern, a grantor trust owned an SMLLC. Both were treated as DEs and the grantor was treated as the S shareholder. 7
A variation on this theme occurred when a husband and wife were grantors of a trust, and both held the power to revoke it, along with certain other powers. 8 The trust then acquired all of the ownership of an SMLLC that held stock in several S corporations. There were two grantors, but the Service apparently reasoned that one of the spouses was treated as the owner of all of the trust property, and did not try to divide the trust into two parts. Had it treated the trust as owned by two persons, the trust would not have qualified because, under Sec. 1361(c)(2)(A)(i), a grantor trust may qualify as an S shareholder only if it is treated as owned by a single U.S. citizen or resident.
Three Layers of Intermediaries
Letter Ruling 200439028 9 presents a variation on the DE theme, with more layers. The essence of the ruling is:
- X is an S corporation, currently
owned by several individuals, including A and
B, who hold shares as tenants by the entirety.
- Under a series of proposed transactions, A and B will sever the tenancy by the entirety, with each receiving half of the X stock.
- The stock will be transferred to Partnership 1 and Partnership 2.
- Partnership 1 is owned by A, Trust 1 and LLC 1. Trust 1 is a grantor retained annuity trust (GRAT).
- LLC 1 is owned by A and Trust 2, an irrevocable trust.
A will be the grantor of Trusts 1 and 2.
- Partnership 2 is owned by B, Trust 4 (a GRAT) and LLC 2.
- LLC 2 is owned by B and Trust 3, an irrevocable trust.
- B will be the grantor of Trusts 3 and 4.
None of the entities will be treated as an association taxable as a corporation for Federal income tax purposes. Exhibit 1 illustrates the structure of the entities after the above transactions.
Trusts 2 and 3 (the irrevocable trusts) have substantially identical terms, except as described below. A is the initial trustee of both. The trusts provide that, during the grantor’s life, the trustee shall pay or apply such sums from income and principal as, in the trustee’s discretion, are necessary or advisable for the health, education, support and maintenance of the grantor’s spouse and descendants (in the case of Trust 2) or the grantor’s descendants (in the case of Trust 3). On the grantor’s death, the remaining trust assets are to be distributed or held in trust for the benefit of the grantor’s spouse and descendants (in the case of Trust 2) or the grantor’s descendants (in the case of Trust 3) in the manner described in the trust instrument. The trustee has the power to add the spouse of any current beneficiary under any trust created under the terms of the irrevocable trusts as an additional beneficiary of that trust.
Trusts 1 and 4 (the GRATs) have substantially identical terms, except as described below. From the date the GRAT is funded until the 20th anniversary of such date, the trustee shall pay the grantor or the grantor’s estate an annual annuity of 7.23% of the initial fair market value (FMV) of the GRAT’s assets. The annuity is to be paid from income, accumulated income and principal, in that order. Any excess income is to be added to principal. At the end of the annuity period, the remaining trust assets are to be distributed or held in trust for the benefit of the grantor’s spouse and descendants (in the case of Trust 1) or the grantor’s descendants (in the case of Trust 4) in the manner described in the trust instrument. The trustee has the power to add the spouse of any current beneficiary under any trust created under the terms of the GRATs as an additional beneficiary of that trust.
The ruling concluded that all of the trusts were grantor trusts, 11 with all the assets treated as owned by the grantors. Because the trusts were grantor trusts, the LLCs and the partnerships were single-owner entities and disregarded.12 Thus, the grantors were treated as owning all the S stock, and the S election was not affected. The tax treatment of the parties is illustrated in Exhibit 2.
The only item of concern in the ruling was the immediate qualification of the corporation for S status. Given the consistency of the tax treatment of each intermediary between the corporation and the individuals, however, it is not surprising that the IRS ruled the corporation eligible for S status.
Although the Service ruled that this arrangement did not violate the S eligibility rules, this network of entities leaves the S corporation’s tax status uncertain. If anything should happen to cause any of the trusts, LLCs or partnerships to become a recognized entity for tax purposes, the corporation would lose its S status immediately.
It is likely that the trusts will continue to qualify as grantor trusts throughout the lifetime of A and B. However, this continuation is not automatic. If A or B should relinquish all powers that cause grantor trust status, the trust would become a separate tax entity. The LLC in which the trust is a member would also become a recognized entity, thus causing the partnership in which the LLC is a partner to become a recognized entity. A partnership, even if owned entirely by persons qualified to be S shareholders, is not an eligible S shareholder. 13
Thus, the parties need to ensure that there is never a change in status of any of the entities involved. More-over, these trusts would not qualify for QSST or ESBT status, because they do not hold S stock directly. It is not sufficient that the pairs of trusts (1 and 2, and 3 and 4) are eligible to hold S stock. It is equally important that each pair be treated as only one entity, or the partnerships will become recognized and the S election will terminate. Admission of a second person or entity to either of the partnerships or LLCs would also cause shareholder disqualification. By paying careful attention to the ownership of these entities, it may be possible to prevent an actual transfer of ownership that would cause termination of the S election. However, no transfer restriction can prevent the legal transfers that take place due to the death of either of the shareholders.
Death of A or B
On the death of either A or B, the actual and deemed owners of the various entities will change and the S corporation election will terminate. Partnerships 1 and 2 will no longer be treated as DEs owned by A and B. For example, Partnership 1 will be recognized as a partnership for tax purposes, with Trust 1, LLC 1 and the estate of A as its partners. Trust 1 will no longer be a grantor trust on A’s death. Accordingly, Partnership 1 will be an ineligible shareholder for S purposes and the S election will terminate.
Sec. 1362(f) provides relief from terminations of S elections when a corporation inadvertently ceases to be a “small business corporation.” Not surprisingly, there are no waiver letter rulings discussing the exact fact pattern outlined above, but there have been numerous rulings in which relief was granted when an ineligible trust inadvertently became an S shareholder. 14 In any situation dealing with an unanticipated S election termination, it is advisable to consider seeking relief under Sec. 1362(f). Regs. Sec. 1.1362-4(c) requires that this relief be requested through a letter ruling (which is relatively expensive).
Letter Ruling 200439028 does not provide details as to why such a complex ownership scheme was necessary. The most troublesome aspect of the fact pattern was the insertion of a partnership and an LLC into the ownership chain. These types of entities, if not treated as DEs, can never be eligible S shareholders. Accordingly, the S election would always terminate on the death of A or B. Omitting these types of entities from a complex structure intended to result in a chain of DEs would always be wise if the overriding tax and business objective is the continuation of the S election. Alternatively, the presence of various types of trusts within such an ownership chain provides certain flexibility that can preserve a desired S election. For instance, on the death of a grantor of a grantor trust, and following the two-year post-death eligibility period under Sec. 1361(c)(2)(A)(ii), it may be possible to qualify the new trust as either a QSST or an ESBT. If either of those two strategies is not possible, the Service’s history of granting waivers of inadvertent terminations involving transfers to nonqualifying trusts is fairly liberal and may provide the relief needed to continue the S election.
Letter Ruling 200439028 provides a comprehensive case study for the ownership of S stock under current IRS policy. The structure involved two types of grantor trusts (irrevocable trust and GRAT), an SMLLC (within the meaning of Regs. Sec. 301.7701-3) and a partnership treated as a DE, all forming a chain of DEs. Because all the intermediate entities were transparent, the individuals at the top of the arrangement were treated as the only S shareholders. The complex ownership arrangement designed by the grantors in this ruling created a fragile environment for the S election, with several possible potential traps that should be anticipated and avoided.
1 Lutrell, “S Corporation Returns,” IRS Statistics of Income Bulletin (Fall 2004), Table 22 (Rev. 12/04).
2 See id.
3 IRS Letter Ruling 200439028 (9/24/04).
4 See id.
5 IRS Letter Ruling 9745017 (11/7/07).
6 IRS Letter Rulings 200107025 (2/20/01) and 200326023 (6/27/03).
7 IRS Letter Ruling 200303032 (1/17/03).
8 IRS Letter Ruling 200339026 (9/26/03).
9 IRS Letter Ruling 200439028, note 3 supra.
10 This is a form of joint ownership with survivorship rights between spouses; it is used in states that do not have community property laws.
11 See Secs. 671–679.
12 See Regs. Sec. 301.7701-2(c)(2)(i).
13 See Regs. Sec. 1.1361-1(e)(1). There is an exception if the partnership is a nominee, and has no beneficial interest in the stock in which it holds title.
14 See, for example, IRS Letter Rulings 8839025 (1/29/88), 8834033 (5/26/88) and 9321033 (2/24/93), holding that transfers to testamentary trusts were inadvertent.