7 minute read
BUSINESS LAW
By Alexandra J.C. Gregorski, MBA, JD and
An S corporation election can be revoked with the consent of shareholders holding more than one-half of the shares of the corporation’s stock. [See Internal Revenue Code (IRC) § 1362(d)(1).] The election can also be terminated in circumstances in which the owners have no intent to do so. Some of these — with particular emphasis on situations in which limited liability companies (LLCs) have elected to be S corporations — are discussed in this article. Tax advisors should help educate S corporation clients about termination situations so clients will be more apt to timely consult with their advisors and avoid them.
John A. Sikora, JD Criteria for S corporation status
An S corporation may not have more than 100 shareholders, and shareholders may be only individuals, estates, certain trusts or certain exempt organizations. None of the individuals may be a nonresident alien. The corporation may not be an “ineligible corporation”1 as defined in IRC § 1361. An S corporation may not have more than one class of stock, which generally means that all shares of stock must confer identical rights to distribution and liquidation proceeds.
1 the term “ineligible corporation” means any corporation which is (A) a financial institution which uses the reserve method of accounting for bad debts described in section 585, (B) an insurance company subject to tax under subchapter L, or (C) a DISC or former DISC. Whether all outstanding shares of stock do so is generally based on the entity’s “governing provisions.”2 Differences in voting rights among shares of stock are disregarded in determining whether the corporation has more than one class of stock.
Failing to meet any of the S corporation requirements results in the termination of the S election. [See IRC § 1362(d)(2).] Recognizing and helping clients avoid events that will terminate the S status is often quite straightforward, such as with respect to application of the 100-shareholder and type-of-shareholder limitations. As to the former, most clients are aware of the limit and seek counsel before issuance of stock to a larger number of owners. As to the latter, avoiding an inadvertent termination is, in some measure, often accomplished by proper provisions
2 Treas. Reg. 1.1361-1(l).
in corporate instruments (usually shareholder or buy-sell agreements and occasionally organizational documents) prohibiting and rendering void transfers of shares to ineligible shareholders. Advisors should recommend execution of documents that include such limiting provisions, as without them one shareholder could, by the transfer of a single share, cause termination of the S status. Other situations may not be as readily apparent to the client, nor perhaps even the client’s professional advisor. Some situations involve entities formed as LLCs, which are — under the entity classification regulations — allowed to elect to be taxed as corporations (as opposed to the default classifications of disregarded entity or tax partnership) and to make an S election. Entities that do so need to be aware that the list of permissible owners is not as extensive as when, for example, it was taxed as a partnership. Instances have occurred in
which advisors, perhaps not fully appreciating the S status of the LLC, have assisted in the admission of new LLC members who were not qualified S entity owners. Such entities, particularly those converting from tax partnership to S corporation status, will need to examine
and likely amend their operating agreements before making an S election and exercise care in executing new agreements or amendments. Private Letter Ruling (PLR) 2020190073 illustrates the hazards of not doing so. In the PLR, the operating agreement of an LLC that had filed an S election provided that liquidation proceeds would be distributed in accordance with capital accounts as opposed to pro rata based on relative membership interests. The capital accounts of the members were also not proportionate to membership interests. The ruling held that the LLC’s S election never became effective because, among other things, rights to liquidation proceeds based on capital accounts, and not pro rata based on membership interests, meant the LLC had more than one class of stock. Instances in which an LLC elects to be taxed as a corporation and also makes an S election are not uncommon. The disqualifying provisions of the operating agreement described in the PLR are often included in typical operating agreements of LLCs taxed as partnerships. Although we are speculating, the PLR seems to involve a situation in which the professional advisors may not have given any thought to the terms of the LLC’s existing governing and organizational documents when making the S election — or perhaps a situation in which the drafter of the operating agreement and the tax advisor may not have communicated well about the importance of proper operating agreement terms. In sum, then, LLC operating agreements must be evaluated and perhaps significantly modified if the tax treatment of the entity will be changing to S corporation status, particularly if an LLC was previously taxed as a partnership. Such entities often have agreements that contain not only disqualifying provisions of the kind referred to in the PLR but also preferred or priority returns, multiple classes of membership interests, different rights to distributions, different rights to tax distributions and other varying economic rights that would likely — under S corporation rules — result in a second class of stock. Some (but not all) of the other circumstances in which taxpayers have seemingly failed to properly appreciate the S election termination provisions are as follows: • S corporation having C corporation earnings and profits with excess passive investment income for three years, resulting in termination under IRC § 1362(d)(3)
• Transfers to or changes relating to trusts following which the trust did not qualify as an S shareholder [See
IRC § 1361(c)(2).] • The admission of a second member to a single-member, disregarded LLC that owned S corporation stock • The issuance of shares subject to a corporate agreement that created a second class of stock
Inadvertent termination relief
Thankfully, under IRC § 1362(f) and Treas. Reg. § 1.1362–4, a corporation may request IRS determination of an inadvertent termination and relief from it. The request is made in the form of a ruling request in which the corporation has the burden of establishing that the termination was inadvertent. Requesting such relief from the IRS is obviously something all S corporations want to avoid. The process is lengthy, and in addition to professional costs, fees are associated with filing the ruling request.
Summary and recommendations
Tax professionals, document drafters and transaction advisors must work closely together when any S corporation transaction or event is considered. Advisors may want to send periodic reminders regarding S election termination risks or establish review procedures regarding governing provisions on a regular basis, at the time of impending transactions and before submission of Form 2553.
Alexandra J.C. Gregorski, MBA, JD, is an attorney in the business practice group at von Briesen & Roper s.c. Contact her at (414) 287-1294 or agregorski@vonbriesen.com. John A. Sikora, JD, is a shareholder in the firm’s tax section. Contact him at (414) 270-2512 or jsikora@vonbriesen.com.
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