Chapter 15 PT 2 Flashcards
What are the eligibility requirements for an S corp?
Eligibility Requirements
- 100 shareholder limit: husband and wife are treated an one shareholder, also applies to family members
- Only certain types of tax persons qualify as “eligible” shareholders
- Permissible affiliate status
- One class of stock
Facts and issues of rev ruling 94-43
Revenue Ruling 94-43
Note that I have revised the numbers to comport with current law (100 shareholder limit)
- 300 individuals desired to form a S Corp
- Clearly, a single S Corporation cannot have 300 shareholders
- These individuals chose to do the following
- They divided the 300 potential shareholders into three groups of 100 each
- Each group of 100 shareholders formed an S Corporation
- The 3 S Corps, in turn, formed a partnership to be the operating company
- Each of the 3 S Corps had an equal ownership in the partnership
- The end result was similar to what would have been achieved if they could have formed a single S Corporation with 300 shareholders
Issue:
Does this work? Is it a means to get around the 100 shareholder limit
Holding:
Yes. This is permissible primarily because it doesn’t add to the overall complexity (i.e., it doesn’t violate the purpose of the shareholder limit rule which is to maintain simplicity!!)
Who are eligible shareholders for S corps?
Eligible Shareholders
- Individuals (other than nonresident aliens)
- Bankruptcy estates
- Decedent’s estates (limited to two years however)
- Certain trusts (see following slides)
- Tax exempt organizations
- Other S Corporations (in limited circumstances)
What are the first 3 types of trusts that can be S corp shareholders?
Trusts
Grantor or revocable trusts (including defective grantor trusts)
- Such trusts ignored for income tax purposes
- No risk of reallocating income and thus defeating the one class of stock requirement
Qualified Subchapter S Trusts (QSSTs)
- Trust beneficiary is taxed directly on the S Corp income even if the trust income is not distributed (note the requirement that income be distributed)
- Allows the use of this trust for estate planning purposes
- Trust beneficiary must elect QSST treatment
Testamentary Trust (Estate)
- Allowed as an eligible shareholder for a period of two years following the death of the decedent
What are the 9 elements of Electing Small Business Trusts (ESBT)?
Electing Small Business Trusts (ESBT)
- Came into the law in 1996
- Allows trusts with “sprinkling” provisions to qualify as S Corp shareholders
- Allows for trusts with numerous beneficiaries
- Beneficial interests must be acquired by means other than purchase – in other words, by gift or bequest
- The trade off for this trust is the fact that the S Corp income allocated to the trust is taxed at the highest marginal rate (today = 35%)
- Trust pays the tax
- Trustee (rather than the beneficiaries) consents to the S election (Form 2553)
- All beneficiaries treated as shareholders for purposes of the 100 shareholder test (after considering the family ownership rule)
- All beneficiaries treated as shareholders for purposes of determining eligible shareholders
What are the issues nonresident aliens as it relates to S corps?
Nonresident Aliens
- A foreign individual (non U.S. citizen) who does not reside in the U.S.
- Residence is based on:
- Green card test
- Substantial presence test
- 183 day test
- Carryover days test
- Nonresident aliens are not permitted as shareholders due to the difficulty in collecting tax from such individuals (note that partnerships are allowed to have nonresident alien partners – income allocated to such partners are subject to withholding)
What are the issues with S corps as S corp shareholders?
S Corporations as S Corp Shareholders
- An S Corporation may own stock in another S Corporation
- However, the shareholder S Corporation must own 100% of the second S Corporation
- An S Corporation may own stock in a C Corporation with no ownership % restriction
What are the corporate level eligibility requirements?
Corporate Level Eligibility Requirements
- Domestic corporation
- Cannot be an “ineligible” corporation – engaged in certain businesses which are not permissible to be held in an S Corp
- Only one class of stock (though voting and nonvoting stock is permitted)
- S Corporation may own interests in a C Corporation (at any level of stock ownership) but can only own another S Corporation when it owns 100% of the other S Corporation’s stock
- S Corporation cannot participate in the filing of a consolidated return
Elements of qualified subchapter S: Q sub
Qualified Subchapter S Subsidiary (Q-Sub)
- Parent S Corp must own 100% of any first tier S Corporation
- Additional lower tier subs can be owned in a Parent-Subsidiary chain (with direct or indirect 100% ownership)
- Parent makes a Q-Sub election and subs are treated as though they are liquidated tax-free (§§ 332/337) ultimately into the parent S Corporation. Though the subs maintain their legal existence, only one tax return is filed since all the subs are deemed to be liquidated into a single parent.
- Once a Q-Sub loses its status as a Q-Sub, the parent is deemed to form the Q-sub as a new corporation in a §351 transaction
One class of stock…
One Class of Stock
- Voting and non-voting stock treated as one class of stock
- Shares must be equal in terms of:
- Income allocation
- Distributions
- Liquidation rights
- Watch out for tax distributions to shareholder – they need to be pro-rata
- Buy-sell, redemption, shareholder agreements governing the disposition of stock rarely cause a problem
Issues of Rev Ruling 85-161
Revenue Ruling 85-161
Facts:
- A, B, C, and D are shareholders of an S Corp
- A, B, and C are all family members
- D is unrelated to A, B, and C
- D’s shares are restricted as to his ability to sell his shares (i.e., A, B, and C must approve his sale – if they don’t approve, D can only sell his shares to the corporation or A, B, or C at “book value” not FMV)
Issue:
Given the restriction on D’s shares, does the corporation have two classes of stock?
Holding: No. The corporation only has one class of stock. All shares, including D’s shares, have the same rights as it related to distributions and the underlying corporate assets.
Do stock warrants and options constitute a second class of stock?
One Class of Stock
- Warrants and stock options
- Generally not treated as a second class of stock
- A non-compensatory option deep in the money will likely be treated as a second class of stock
- Restricted stock will not be treated as outstanding (and hence not run the risk of being a second class of stock) unless an §83(b) election has been made at which time the restricted stock will be treated as outstanding and must not violate the second class of stock rule
Debt as a second class of stock
Debt as a Second Class of Stock
- Regulations provide a safe harbor such that “straight debt” will not be treated as stock
- Straight debt =
- Created by a written and unconditional promise to repay
- Repayable in money
- Carrying a fixed, non-contingent interest rate and interest payment dates
- Not convertible into stock, and
- Having as its creditor either an individual, estate or trust that is eligible to qualify as an S shareholder or a person in the active and regular business of loaning funds
Ltr Ruling 8819040
Avoiding Corporate Limitations - Ltr. Rul. 8819040
Facts:
- X, an S corporation, is in the business of managing hotels
- In order to expand its operations, X joins in a partnership with Y, a C corporation
- X contributes its assets and liabilities to the partnership in exchange for an 84% interest in the partnership
- Y contributes cash and the promise to provide future capital if needed for its 16% interest in the partnership
- The partnership will continue the existing business of X and will expand the business with additional funding from Y
- X will expand into other businesses separate and apart from the partnership – Y will not have any interest in these other businesses
Issue:
Given the structure listed above, will X continue to qualify as an S Corporation?
Holding:
Yes
Ineligible shareholders: ltr ruling 8814042
Impact of Ineligible Shareholders – Ltr Rul 8814042
Facts:
- Company filed an election to be treated as an S corporation for its tax year beginning D1.
- On D1, one of the shareholders of Company stock was A’s estate
- The executrix of A’s estate consented to Company’s S election on behalf of A’s estate
- On D2, pursuant to the terms of A’s last will and testament, the one share of Company stock held by A’s estate was transferred to Trust
- Trust held the share of Company stock beyond (what today) is the 2-year rule
- Neither Company nor its officers were aware that Company’s S election would be terminated because Trust held the share of Company stock beyond the 2-year period
- Following this period, the tax return preparer notified management that the Trust was an ineligible shareholder and that the corporation had lost its S election
- B, the president of the company, immediately bought the one share held by the trust and the parties treated the corporation as though it had not lost its S status
Holding:
IRS granted the corporation its continuing status as an S corporation since action was taken to eliminate the problem (i.e., the ineligible shareholder) and such problem was inadvertent.
