Structuring stock dispositions to prevent S election termination

A disposition of stock may result in termination of a corporation’s S election. Whether inadvertently or intentionally, individual S shareholders might sell, give, or exchange some or all of their stock in a manner that results in the corporation’s losing its S election.

Exceeding the shareholder limitation

One way the S election can be terminated is if the disposition results in more than the maximum allowable number of shareholders. For example, when two or more individuals own stock as tenants in common or joint tenants with the right of survivorship, and they are not married or members of the same family, each one is a separate shareholder (Regs. Sec. 1.1361-1(e)(1)). Or, if stock is held by an electing small business trust (ESBT), each potential current beneficiary is counted as a separate shareholder (Regs. Sec. 1.1361-1(m) (4)). Either situation makes it more likely that the 100-shareholder limit (Sec. 1361(b)(1)(A)) will be exceeded, sometimes unexpectedly.

Transferring stock to an ineligible shareholder

A second way the S election can be terminated is if the stock is transferred to an ineligible shareholder. Only certain individuals, estates, and trusts are eligible shareholders. There is no time limit to a decedent’s estate holding S stock, but if the estate remains open past a reasonable period, it may be recharacterized as a trust ineligible to hold S stock. Eligibility of a testamentary trust that receives S stock under the terms of a will is generally limited to a two-year period of ownership from the date stock is transferred to the trust (Sec. 1361(c)(2) (A)(iii)). However, status as an electing qualified Subchapter S trust (QSST) or ESBT for a qualifying testamentary trust can keep the S election in effect after the two-year period expires.

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, 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, nonqualifying trust, or nonresident alien.

Whenever even a single share of stock is transferred to an ineligible shareholder in a bona fide transfer, the courts will support the termination of S status (see T.J. Henry Associates, Inc., 80 T.C. 886 (1983)). However, where 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 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 F.3d 1 (1st Cir. 1997)).

Example. Preventing a dissident shareholder from transferring stock: T 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 corporation’s management, and the brothers are concerned that these children may not recognize the importance of S status.

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

However, one or more of the children could readily terminate the corporation’s S status by simply forming a corporation to hold one or more shares of their stock, or by forming a complex trust to act as a shareholder. Such a transfer of stock would cause termination of S status on the date of transfer.

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, and a legend should be added to the stock certificates referring to the shareholder agreement and the specific provisions restricting transfer rights. Additional strategies that might minimize the risks of having the children as shareholders include the following:

• The stock issued to the children could be limited to nonvoting common stock, which would not create a second class of stock.
• Make annual distributions of income. 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 wants to terminate the corporation’s S status, the bona fide transfer of even a single share to an ineligible holder will cause a termination. To prevent this, the shareholders should make a practice of distributing income and create a shareholder agreement that restricts the shareholders’ ability to transfer stock to outsiders.

Nominal versus actual transfer of stock

If a minority shareholder transfers stock to an ineligible shareholder, the corporation might attempt to argue that beneficial ownership of the stock had not been transferred to the ineligible recipient if the facts indicate the new owner had not assumed full control of the stock.

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 T.C. 267 (1966), 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 S election did not terminate its S status under prior law. Similarly, in Auld, T.C. Memo. 1978-508, the court held that an S corporation shareholder’s son to whom the shareholder transferred a portion of his stock was not the beneficial owner of the stock, so the son’s actions did not terminate the corporation’s S status under prior law.

Using a buy/sell agreement to prevent a stock transfer to an ineligible shareholder

A buy/sell agreement can be used to prevent a transfer of stock by a shareholder to an ineligible shareholder by requiring the shareholder to first offer the stock to the corporation and the other existing shareholders before any transfer can be made to outside parties. To further solidify such an arrangement, the corporation’s 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 for transfer tax purposes without regard to (1) an option, agreement, or other right to acquire the property for less than its 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 Sec. 2703(b) requirement above contemplates proof that the right or restriction found in the agreement is comparable to what could have been obtained in a fair bargain among unrelated parties in the same type of business. This determination involves consideration of the expected term of the agreement, the current market value of the stock, anticipated changes in the value of the stock 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 of business if it 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 generally 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 (Regs. Sec. 1.1361-1(l)(2)(iii)). A safe harbor is provided for agreements that establish a purchase price between the stock’s book value and its FMV.

Other possible buy-sell agreement provisions to protect S corporation status are (1) including a requirement that a shareholder notify the corporation when a prospective transfer is contemplated and requiring that a transfer agent be appointed to verify that a prospective transfer does not terminate the S election; (2) providing (if permitted under local law) that prohibited transfers are void immediately rather than merely voidable; and (3) inserting an indemnification clause to protect the remaining shareholders from the loss of S status following a prohibited transfer.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.