Structuring stock dispositions to prevent Selection termination.

Date01 August 2023
AuthorHunley, Shaun M.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

A disposition of stock may result in termination of a corporation's Selection. Whether inadvertently or intentionally, individual S shareholders might sell, give, or exchange some or all of their stock in a manner that results in the corporation's losing its Selection.

Exceeding the shareholder limitation

One way the S election can be terminated is if the disposition results in more than the maximum allowable number of shareholders. For example, when two or more individuals own stock as tenants in common or joint tenants with the right of survivorship, and they are not married or members of the same family, each one is a separate shareholder (Regs. Sec. 1.1361-l(e)(1)). Or, if stock is held by an electing small business trust (ESBT), each potential current beneficiary is counted as a separate shareholder (Regs. Sec. 1.1361-l(m) (4)). Either situation makes it more likely that the 100-shareholder limit (Sec. 1361(b)(1)(A)) will be exceeded, sometimes unexpectedly.

Transferring stock to an ineligible shareholder

A second way the S election can be terminated is if the stock is transferred to an ineligible shareholder. Only certain individuals, estates, and trusts are eligible shareholders. There is no time limit to a decedent's estate holding S stock, but if the estate remains open past a reasonable period, it may be recharacterized as a trust ineligible to hold S stock. Eligibility of a testamentary trust that receives S stock under the terms of a will is generally limited to a two-year period of ownership from the date stock is transferred to the trust (Sec. 1361(c)(2) (A)(iii)). However, status as an electing qualified Subchapter S trust (QSST) or ESBT for a qualifying testamentary trust can keep the S election in effect after the two-year period expires.

A corporation can also lose its S status 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, a minority shareholder can unilaterally cause...

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