S Corporations and disregarded entities-qualification as shareholders: S stock ownership is often diversified by using disregarded entities (DEs) in complex ownership structures. This article discusses recent strategies, rulings and pitfalls involving DEs and S shareholder eligibility.

• Author: Harmon, Michael R.

EXECUTIVE SUMMARY

* S corporations may be owned through a network of trusts, partnerships and LLCs when DEs are properly used.

* Letter Ruling 200439028 presents a variation on recent ownership schemes, with a layered structure involving DEs.

* The intertwining structure of complex ownership networks often leaves the S corporation's eligibility status uncertain.

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Recent statistics indicate that over 3 million S corporations filed returns for the 2003 tax year; the total is expected to exceed 3.5 million for 2004. (1) S corporation filings exceed partnership filings by approximately 1 million; further, there are more new S corporations than new partnerships. (2) Thus, the S corporation continues to deserve significant attention by tax planners and policy makers.

S corporations have some unique eligibility rules, such as the maximum number and eligible types of shareholders; further, the entity can issue only a single class of stock. This article discusses some recent structuring ideas to expand ownership, yet remain within the S corporation limits. Although the structures discussed may diversify the actual beneficial ownership, they do not alter the Federal income tax reporting of the corporation's income and losses by the ultimate shareholder.

Several taxpayers have received letter rulings concerning complex situations in which S stock was owned by trusts, partnerships and limited liability companies (LLCs). Some of these ownership structures appear to violate the S corporation ownership rules. However, because some of the holders were treated as disregarded entities (DEs), the stock was nevertheless treated as being owned by an individual and the S election was safe. Even though the ownership patterns may be varied, tax professionals should exercise caution in recommending them. Tax payers, and the tax advisers who put them into these complex ownership arrangements, may learn, to their dismay, that the S election is in serious jeopardy. Anything that alters the tax treatment of any of the entities involved (even the death of one of the parties) may endanger the corporation's S election.

This article also reviews a recent ruling (3) in detail; it presents some significant potential problems that might exist when a grantor dies (or there is any other change of ownership), and suggests actions to take to save the S election.

Background

Subchapter S was adopted in 1958 and materially amended in 1982. Throughout its entire history, rules have limited the number and types of shareholders. The original rules allowed only 10 shareholders at any one time, all of whom had to be individuals or estates. No form of trust could own stock in an S corporation (then known as an "electing small business corporation" or a "subchapter S corporation"); even voting trusts and grantor trusts were prohibited.

Over the years, the law was amended to permit additional shareholder types and greater numbers. Currently, under Sec. 1361(b)(1)(A), there may be up to 100 shareholders, with some rather generous family attribution rules under Sec. 1361(c)(1)(A)(ii). Five basic types of trusts are allowable shareholders, under Sec. 1361(c)(2):

1. A grantor (or deemed grantor) trust throughout the lifetime of the deemed owner and up to two years after his or her death;

2. A testamentary trust, for two years after it is funded;

3. A qualified subchapter S trust (QSST), for which the beneficiary has elected to be treated as the deemed owner of the S stock (there are rigid requirements);

4. An electing small business trust (ESBT), which pays tax on income...