Avoiding an Inadvertent Termination of S Corporation Status

An inadvertent termination of a company’s S corporation status can mess up even the best tax planning intentions. Here are some important considerations and suggestions to help avoid an inadvertent loss of the company’s qualification to be treated as an S corporation.

100-shareholder limitation. The S election will terminate if the number of S corporation shareholders is more than 100 at any time during any year. Therefore, it is important to monitor future stock issues so that the 100-shareholder limitation will not be exceeded. A shareholder agreement can help avoid termination of the S election by prohibiting the transfer of shares that would result in more than 100 shareholders.

Ineligible shareholders. An S corporation can generally have only shareholders that are (1) individuals who are U.S. citizens or residents, (2) estates, and (3) certain types of trusts. Ineligible shareholders include nonresident aliens, partnerships, corporations, and nonqualified trusts. Therefore, it is important to continually ensure that all the shareholders are eligible to hold S corporation stock.

A shareholder agreement is one of the most important tools available to protect the corporation’s S election from termination because shares have been transferred to an ineligible shareholder. Such an agreement should prohibit the transfer of any shares to a person other than a permitted S corporation shareholder.

One class of stock. An S corporation can have only one class of stock. This means that all outstanding shares must confer identical rights to distribution and liquidation proceeds. The rules do provide, however, that an S corporation can issue both voting and nonvoting stock without violating the one-class-of-stock rule. This rule is complicated, so be sure to contact us when considering future changes to the capital structure of the corporation or when drafting agreements that may affect distribution and liquidation rights.

Excess passive investment income. If a corporation has more than 25% of its gross receipts from passive investment sources in three consecutive years and has C corporation Accumulated Earnings and Profits (AE&P) at the end of each year, then S status is terminated as of the beginning of the fourth consecutive year. An S corporation will generally have AE&P only if it previously operated as a C corporation or acquires a C corporation in a tax-free reorganization.

Corporate records tracking the corporation’s passive investment income should be maintained to determine whether the 25% limitation will be exceeded. If a corporation is in danger of going over the 25% passive income limitation for three consecutive years, termination of the corporation’s S status can be avoided by distributing the AE&P to shareholders. Furthermore, if the corporation lacks the cash or liquid assets to make the distributions, the corporation can elect to make a “deemed” dividend. If such an election is made, the corporation acts as though a distribution has been (1) paid to the shareholders and (2) contributed back to the corporation. Any distribution of AE&P, however, whether actual or deemed, is taxable to shareholders as a dividend.

If distributing the AE&P is not feasible, it may be possible to avoid termination under the passive income rules by arranging the corporation’s operations so that the 25% passive income limit is not exceeded for three consecutive years. To accomplish this, the corporation could (1) reduce the amount of passive investment income, (2) increase the amount of other income, or (3) do a combination of both.

Let us help. These rules are complex, and some of the procedures apply only if special tax elections are properly filed with the IRS. If you have any questions or if you are considering implementing any of these procedures, please contact Martini, Iosue & Akpovi by phone at (818) 789-1179.

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