Preserving Subchapter S Election

Avoid transfers to ineligible shareholders. In general, only individual U.S. citizens or residents, decedent estates, certain types of trusts, and certain exempt organizations may be S corporation shareholders. Therefore, it is important that you confirm that all the shareholders are eligible shareholders, i.e., (i) that no shareholder is a nonresident alien, a partnership, or a corporation; (ii) that all trusts are properly structured to be eligible shareholders, and (iii) that any election required for a trust shareholder are made.

Even if a corporation's initial shareholders are all eligible shareholders, its S corporation status will terminate if any shares are transferred to a nonresident alien individual, a corporation, a partnership, or a trust (other than the specific types of trusts which may be S corporation shareholders).

In order to prevent a shareholder from terminating an S corporation's status by transferring his shares to an ineligible shareholder, a shareholders' agreement should prohibit transfers of any shares to any person other than a permitted S corporation shareholder and require a similar undertaking on the part of any transferee as a condition to any transfer. In addition, if permitted by local law, a restriction should be imposed in the corporation's charter or by-laws that would void a purported transfer to an ineligible shareholder.

Avoid violating the shareholder limitation. An S corporation cannot have more than 100 shareholders at any time. Even if this limit is not exceeded at organization, the S status will terminate if the limit is exceeded at any time in the future, whether as a result of new issuances or transfers of shares.

New issuances of stock require corporate action. You should keep this in mind when considering future issuances of stock to avoid exceeding the 100 shareholder limit.

Transfers by shareholders can be somewhat more problematic, since they can occur without any action on the part of the corporation. Therefore, a shareholders' agreement should prohibit any transfer of shares to a person who is not already a shareholder or if the transfer would cause the 100 shareholder limit to be exceeded and transfers should be conditioned on the transferee being subject to the same restriction. If permitted by local law, an appropriate restriction should also be imposed in the corporation's charter or by-laws so that a purported transfer that caused the limit to be exceeded would be void.

Don't issue more than one class of stock. An S corporation can only have one class of stock. Be sure to keep this requirement in mind when considering future changes to the capital structure of the corporation, including purported debt owed by the corporation that may be recharacterized as equity. The IRS allows S corporations to use various equity incentive compensation arrangements without violating the one class of stock restriction. If you want to create an equity incentive compensation plan, I would be happy to discuss with you how to structure the plan.

Avoid excess passive investment income. If an S corporation has accumulated earnings and profits (because it was once a C corporation or is a transferee of a C corporation), its S election will terminate if, for a period of three consecutive tax years, its “passive investment income” exceeds 25% of its gross receipts.

The first step in avoiding an inadvertent termination under this rule is to keep track of the corporation's passive investment income to determine whether the 25% limitation may be exceeded. Although excess passive income is subject to a special tax, S corporation status will terminate only if the limit is exceeded for three consecutive years. Thus, if you are willing to pay the tax, you can monitor the results of two years' operations while you plan to avoid a termination.

If a corporation is in danger of exceeding the 25% passive income limitation for three consecutive years, there are two basic approaches to avoid termination of S corporation status. Since termination will only occur if the corporation has accumulated earnings and profits from C corporation years, termination can be avoided by stripping out those earnings and profits by way of a dividend. Ordinarily, distributions by an S corporation reduce pre-S corporation earnings and profits only after the accumulated income from all S corporation years has been distributed. However, it is possible to elect to treat distributions as coming from pre-S corporation earnings and profits first. Moreover, if it desired to strip out earnings and profits without actually depleting the corporation's cash or other liquid assets, a “deemed” dividend election can be made. Be aware, however, that a distribution out of pre-S corporation earnings and profits (whether actual or under the deemed dividend election) is generally taxable to shareholders as a dividend (unlike a distribution from accumulated S corporation income which is generally a return of capital).

A second approach to avoiding termination under the passive income rules is to tailor the corporation's operations so that the 25% passive income limit is not exceeded. Since termination will occur only after the limit is exceeded for three consecutive years, if you are willing to incur the tax on excess passive income, there should be sufficient time to take action to avoid a termination.

This can be done by reducing the amount of passive investment income, or by increasing the amount of other income. Since the test is applied to gross receipts, acquiring a business which produces receipts which are not passive investment income, even if it does not produce much in the way of net income, is one possible solution. It may also be possible to restructure certain operations so that passive income (e.g., certain rental income) becomes active income. (Unfortunately, an investment in municipal bonds producing tax-exempt interest is not a solution under these rules.)