Most S Corp. owners realize there are some challenges that must be considered in order to maintain their S-election. I have focused on corporations that have been treated as S corporations effectively since formation in this article. The S Corporation election can be inadvertently terminated in several ways. But with some preplanning and some prompt action by the taxpayer and tax practitioner, the IRS does have some relief measures to mitigate the consequences.
Three Ways a S Corp. Status can Inadvertently be Terminated
Unintentional termination of an S Corp Status as explained by IRC Section 1361(b):
- More than 100 shareholders – if a corporation is close to the limit, a shareholder can inadvertently cause a problem by a sale of his interest
- More than one class of stock – All shares of stock must have identical rights to distribution and liquidation proceeds. Future changes to the capital structure of the corporation, including debt owed by the corporation that may be re-characterized as equity, could create a second class of stock. Disproportionate distributions could also terminate the S election.
- Ineligible shareholders – S corporations cannot be owned by C Corporations, partnerships, ineligible trusts, or non-resident aliens. Transfer of shares to ineligible shareholders will terminate the S Corp. Election.
Ways to Limit the Inadvertent Termination
A shareholder’s agreement should prohibit transfers of any shares to any person other than a permitted S corporation shareholder and require a similar review of any transferee’s status as a condition of any transfer. The agreement should also prohibit any transfer of shares to a person who is not already a member if the transfer would cause the 100 shareholder limit to be violated.
A buy-sell agreement should be considered for shares held by resident alien individuals, forcing them to sell the shares before they become a nonresident alien individual.
Relief for Inadvertent Terminations
If certain conditions are met, a corporation can continue as an S Corporation despite the occurrence of a terminating event. IRC Sec 1362 (f) provides the IRS can provide relief if the following circumstances are present:
- The corporation previously made a valid S Corporation Election and that election was terminated.
- The S Corp. status was terminated by an inadvertent act
- The IRS determines that the termination was inadvertent.
- Steps are taken within a reasonable period to correct the condition that rendered the corporation ineligible to be an S Corp.
- The corporation and shareholders agree to make any adjustments the IRS requires that are consistent with the treatment of the S corp.
What You Do to Prevent an Inadvertent Termination
A shareholder’s agreement and buy-sell agreement should be adopted. In addition, yearly tax planning is a good time to conduct ongoing due diligence relating to the S corp. status.