IRS ruling liberalizes S limits on number of shareholders.

• Author: Belkin, Eileen

The IRS has recently issued a favorable revenue ruling that should give corporations more flexibility in the structuring of corporate entities by allowing business groups with more than 35 shareholders to elect S status. In Rev. Rul. 77-220, the Service did not allow three separate corporations to make valid S elections. The three separate corporations had 10 shareholders each and were operating one business linked by a single partnership (at the time of the ruling, S corporations were limited to no more than 10 shareholders). The IRS ruled that, for purposes of the S election, the three corporations would be considered a single corporation, thereby making the S election invalid. Apparently, the only reason for the three separate corporations was to qualify to make S elections.

In Rev. Rul. 94-43, revoking Rev. Rul. 77-220, the Service stated that the proposed structure did not affect "administrative simplicity."

The purpose of the number of shareholders requirement is to restrict S corporation status to corporations with a limited number of shareholders so as to obtain administrative simplicity in the administration of the corporation's tax affairs. In this context, administrative simplicity is not affected by the corporation's participation in a partnership with other S corporation partners; nor should a shareholder of one S corporation be considered a shareholder of another S corporation because the S corporations are partners in a partnership.

The number of shareholders that an S corporation can have has increased from 10 in 1958, to 15 in 1976, to 25 in 1981 and finally to the present 35 in 1981 (Sec. 1361(b)(1)(A)). In 1982, the Senate Finance Committee Report stated that the 35-shareholder limit corresponded to the private-placement exception under Federal securities law. The intention appears to have been to place limitations on the use of an S corporation as a vehicle for raising capital through a public offering or a private placement.

Of course, the 35-shareholder limitation restricts not only businesses that could potentially raise...