Controlling the number of eligible shareholders in an S corporation.

• Author: Ellentuck, Albert B.
• Position: Case Study

Facts: Galvin, Inc. is a family-controlled publishing company. The company was formed about 40 years ago by three brothers, who are now quite elderly. The three Galvin brothers, their children, grandchildren and various spouses of the children and grandchildren hold all the stock. The company had always operated as a C corporation, but recently converted to S status. This change has worked well, allowing the corporation to avoid incurring corporate tax before issuing small dividends and allowing the shareholders to receive larger cash distributions without double taxation. * The controller of Galvin, Inc. is concerned that the corporation may be about to exceed the current S corporation limit of 75 shareholders. The controller believes that there are 73 shareholders for eligibility purposes, but has raised the following issues:

1. One of the elderly brothers is terminally ill. According to his will, his stock will pass directly to his surviving spouse, but only after an anticipated two-year period of estate administration. His wife is already a direct shareholder on her own.

2. One of the Galvin grandchildren, Glenda Jones, is about to divorce her husband, Tom; Glenda is a shareholder and Tom is not.

3. Another grandchild, who holds only 10 shares of stock, has suffered severe financial difficulties as part owner of a failed business venture. The grandchild guaranteed a number of business debts and may be forced into bankruptcy.

   Recognizing the likelihood that the number of stockholders will continue to increase and present a threat to the corporation's S eligibility, the controller has two suggestions:

1. Form a partnership within each family group to hold its stock, thus reducing the number of shareholders.

2. If a partnership is not viable, use some other conduit entity, such as a simple trust or another S corporation, to serve as a "holding company" shareholder.

   Issue: Can Galvin, Inc. maintain its S status eligibility (in terms of staying within the 75-shareholder limit), given the various changes in stockholder circumstances?

   Analysis

   The corporation's tax adviser should first verify the controller's determination that the current shareholder count is 73. For the 75-shareholder limit, a husband and wife are counted as one shareholder. (This rule applies whether the spouses hold stock individually or jointly.) After verifying the shareholder count, the tax adviser should address each issue facing the corporation.

   Stock Passing to an Estate

   ...