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Avoid Loss of Subchapter S Corporation Status Caused By Transfer of Stock to Ineligible Shareholders

Several community banking organizations converted to S corporation status under the Internal Revenue Code to obtain tax advantages granted to S corporations.  At the time of conversion, only those shareholders eligible under the Internal Revenue Code to hold S corporation stock were permitted to remain as shareholders of the banking organization.  Typically, the banking organization also took steps at that time to prevent a subsequent transfer of stock to a shareholder ineligible under the Internal Revenue Code to hold S corporation stock.  If transfers of stock are not closely monitored, a transfer to an ineligible shareholder could inadvertently occur and cause the loss of S corporation status for the banking organization.  This article addresses steps which could be taken to help prevent an inadvertent transfer of stock to an ineligible shareholder.

Very generally, eligible shareholders include individuals who are U.S. taxpayers and permanent residents, qualified subchapter S trusts, some voting trusts, certain testamentary trusts, certain types of grantor trusts, such as revocable grantor trusts, ESOPs and certain qualified retirement plans and charitable organizations.  Very generally, ineligible shareholders include nonresident aliens, C corporations, partnerships, LLCs, foreign and certain other trusts, and IRAs (unless the IRA held the stock as of October 22, 2004).  Importantly, even though grantor trusts are generally deemed eligible shareholders, the Internal Revenue Code provides for a limited two-year grace period for such a grantor trust to remain an eligible shareholder following the death of the grantor.  During those two years, certain elections must be made by the trust or the trust will become an ineligible shareholder after the two year grace period expires.

Usually the articles of incorporation for an S corporation provide that transfers of stock which have the effect of disqualifying the organization as an S corporation are prohibited.  In addition, many S corporations require shareholders to enter into shareholder agreements that include transfer restrictions.  Nevertheless, any transfer of stock to an ineligible shareholder whether prohibited or not will result in the loss of the organization’s S corporation status effective on the transfer of stock to the ineligible shareholder.  Clearly, the risk to the organization in this process is that a stock transfer to an ineligible shareholder whether prohibited or not will result in the loss of the organization’s S corporation status.

I suggest the organization maintain a robust monitoring program of all transfers of stock to make certain none of those transfers would be to ineligible shareholders.  If the proposed shareholder is ineligible, the organization likely has all of the authority necessary under its articles of incorporation and shareholder agreement to step in and prevent the proposed transfer to the ineligible shareholder.  The key to this monitoring program is of course the maintenance of procedures and responsibilities for monitoring proposed transfers of stock on a regular and continuing basis along with a reasonable understanding of the definition of ineligible shareholders.  Even with a robust plan for monitoring transfers, however, certain proposed transfers will be difficult to evaluate based solely on the proposed title to the transferred stock.  For example, if the proposed transfer is to a trust it may be necessary for the organization to obtain a certificate of trust or an opinion of counsel for the trust confirmation that the trust is eligible to hold S corporation stock.

In addition to monitoring stock transfers, the organization also needs to be aware of the death or incapacitation of the grantor under an eligible grantor trust.  With respect to such trusts, the death of the grantor will trigger a two year grace period for the trust during which it must take certain steps to remain an eligible S corporation shareholder.  Generally, the trust must make a required election on a timely basis within the two year period to remain an eligible shareholder.  In addition, in certain circumstances, if the grantor is formally adjudicated as incapacitated, the trust may inadvertently become ineligible.  It may be important to alert shareholders to their obligation to notify the organization on a timely basis of such events so that the organization may be proactive in securing the necessary elections by those trusts.  It may also be helpful for the organization to suggest to those grantor trust shareholders that they make the necessary elections prior to the death of the grantor and thereby avoid jeopardizing the eligibility of those trusts as shareholders.

Notwithstanding the loss of the organization’s S corporation status following a transfer of stock to an ineligible shareholder, it may be possible for the organization and its shareholders to obtain a waiver of the terminating event from the Internal Revenue Service on grounds of “inadvertency.”  There is a procedure under Internal Revenue Service regulations for obtaining such a waiver.  Furthermore, the shareholder agreement between the organization and its shareholders may include fee shifting provisions making the shareholder who is responsible for the transfer to an ineligible shareholder responsible for the payment of expenses incurred by the organization in obtaining the waiver from the Internal Revenue Service. 

So, be watchful of proposed transfers of stock.  They need to be carefully monitored and evaluated.  The law is complex and some shareholder trusts may be complicated.  Navigating your way through all of this can be difficult.  I suggest your organization consider including its tax advisors on its monitoring team. 

DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.

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