Preventing a dissident shareholder from transferring stock to cause a loss of S status.

• Author: Ellentuck, Albert B.

When a corporation first elects S status, all shareholders of the corporation must consent to the election (Sec. 1362(a) (2)). However, once S status is in place, new shareholders, whether acquiring stock by purchase or gift, need not consent to the election, nor are they given the opportunity to consent. A voluntary revocation of S status can occur only when shareholders owning more than 50% of the corporation's stock consent in writing to a termination of S status (Sec. 1362(d)(1)).

A corporation can also lose its S stares by ceasing to meet the eligibility requirements for S corporations (Secs 1362(d)(2) and 1361(b)(1)). Most of the eligibility requirements are within the corporation's control and could not be influenced by one or two dissident minority shareholders (for example, creating a second class of corporate stock, earning excessive passive income, conducting business as an insurance company, etc.). However, one major criterion for S corporation eligibility is within the control of a minority shareholder: the requirement that an S corporation not have as a shareholder a person other than an individual (other than a nonresident alien), estate, or certain masts (Sec. 1361(b) (1) (B)).

A minority shareholder can unilaterally cause the termination of S status for the corporation by transferring one or more shares to an ineligible shareholder. Examples include a transfer of S corporation stock to a corporation, a nonqualifying mast, or a nonresident alien.

If a dissident minority shareholder should transfer stock to an ineligible holder, the corporation might attempt to argue that beneficial ownership of the stock had not actually transferred to the ineligible recipient if the facts indicate that the new owner had not assumed full control of the stock. Under prior S corporation rules (in an era when a new shareholder's consent to S status was required), it was not unusual to attempt a termination of S status by transferring one share to a party who would decline to consent to the S status.

The courts have on several occasions held that a nominal transfer, when the new owner did not assume full economic control and ownership of the stock, would be disregarded for termination purposes. The courts used a facts-and-circumstances test to scrutinize the economic reality of stock transfers, viewing such matters as the consideration paid for the transfer of the shares, the degree of control exercised by the new owner, etc. In Hook, 58 TC 267...