Avoiding Catastrophe: Preventing S Corporation Inadvertent Terminations With Thoughtful Shareholders’ Agreement Provisions

Kolbie R. Deamon
Associate, Tax Department
Amy E. Drake
Counsel, Tax Department
Published: New Hampshire Bar News
February 19, 2020

The election to be taxed as an S corporation for U.S. federal tax purposes has undergone a resurgence as the choice for owners of closely-held businesses due to the benefits of pass-through taxation combined with the new Qualified Business Income deduction under IRC §199A.

Inadvertent Termination of the S Election

The inadvertent termination of a company’s S corporation election can have dire consequences, namely that the company will be retroactively taxed as a C corporation as of the date of the inadvertent termination.  If a company’s S corporation status is terminated, it cannot re-elect S corporation status for five years without IRS consent.

Pursuant to IRC §1362(d)(2), an entity’s S corporation election automatically terminates upon the occurrence of any event that causes it to cease being a “small business corporation,” as defined in IRC §1361(b)(1).  An entity will cease being a small business corporation if at any time it issues a second class of stock, acquires more than 100 shareholders, or has an ineligible shareholder.  Ineligible shareholders include nonresident aliens and shareholders other than individuals, estates, certain trusts permitted to hold S corporation stock under IRC §1361(c)(2), and certain tax-exempt organizations.

IRS Revenue Procedure 2013-30 offers a simplified process for requesting relief from inadvertent termination in certain circumstances, including relief for late-filed elections for electing small business trusts (“ESBTs”), qualified subchapter S trusts (“QSSTs”), and qualified subchapter S subsidiaries (“QSubs”). These requests must be made with 3 years and 75 days after the effective date of the late election.

Requests for relief for late-filed elections that fall outside this time period and all other requests for relief from inadvertent termination must be made in the form of a request for a private letter ruling under IRC §1362(f).  The current standard filing fee for requesting a letter ruling is $30,000, which does not include legal and professional fees incurred in preparing the request.  Moreover, requests for letter rulings must closely adhere to highly specific and complex technical requirements published by the IRS, further resulting in significant legal and professional fees.

Avoiding Inadvertent Termination

A carefully drafted shareholders’ agreement is critical to protect an S corporation and its shareholders against the consequences of an inadvertent termination.  Including protective provisions in a shareholders’ agreement may be preferable to including them in a corporation’s bylaws because in the case of a shareholders’ agreement, new shareholders are required to affirmatively consent to the restrictions contained therein. In addition, similar protective provisions should be included in a limited liability company operating agreement in the case of a limited liability company that has elected to be taxed as an S corporation.

Direct Transfers Causing Termination

A well-drafted S corporation shareholders’ agreement will provide that any transfer of shares by an S corporation shareholder to an ineligible shareholder is deemed null and void as of the date of the attempted transfer. The agreement may also provide that the S corporation is deemed to have redeemed the shares transferred to an ineligible shareholder as of the date of the attempted transfer.  Since the prohibited transfer is deemed ineffective retroactive to the date of the intended transfer, the inadvertent termination of the company’s S corporation is prevented.  The S corporation would then likely file amended return(s) reflecting the ineffectiveness of the transfer to the ineligible shareholder and the shareholders would also agree to file amended returns in this circumstance.

Indirect Transfers Causing Termination

A second cause for concern that is less commonly addressed is any change in an eligible S corporation shareholder’s status that causes the shareholder to become an ineligible shareholder, sometimes referred to as an “indirect transfer.”  For example, the following events would cause an eligible S corporation shareholder to become an ineligible shareholder:

·       A grantor trust beneficially owned by an eligible S corporation shareholder becomes a non-grantor trust and fail to make a timely EBST or QSST election.

·       A disregarded entity owned by an eligible S corporation shareholder becomes either a partnership (i.e., by adding an additional owner) or corporation.

·       An individual shareholder becomes a nonresident alien.

In each of these cases, the shareholder may not immediately inform the S corporation of its change in status and the company may not otherwise have knowledge of the shareholder’s change in status (for example, a non-grantor trust may keep the same taxpayer identification number as the prior grantor trust).

To protect an S corporation from the inadvertent termination of its election, the shareholders’ agreement should treat indirect transfers causing an inadvertent termination, when discovered by the S corporation, similarly to prohibited direct transfers.

One Class of Stock – Non Pro Rata Distributions

Because S corporations may only have one class of stock under IRC §1361(a)(1)(D), all distributions from an S corporation should be pro rata to the owners.  Thus, an S corporation’s governing documents should ensure that all distributions made to shareholders are required to be pro rata, including tax distributions to cover a shareholder’s taxes on pass-through income.  In addition, if an S corporation makes any payments on a shareholders’ behalf, including, for example, payments to a taxing authorities in satisfaction of a shareholder-level tax liability, the S corporation should make a corresponding pro rata distribution to the other shareholders.  Note that an S corporation does not violate the one class of stock rule by issuing stock with differences in voting rights.

Agreement to Join in Corrective Action to Cure Inadvertent Termination

Finally, a carefully drafted shareholders’ agreement should include a provision that each shareholder agrees to perform any action necessary to prevent or correct the inadvertent termination of the S corporation’s status.  If any shareholder refuses to join in the S corporation’s corrective action for the purpose of curing its inadvertent termination, the shareholder can unilaterally prevent the S corporation from seeking relief from its inadvertent termination or seeking.  Such corrective action could include filing amended returns or joining with the S corporation in filing a private letter ruling request for relief from inadvertent termination.