After making a subchapter S election, S corporations often forget to monitor their status to ensure it stays effective. When a shareholder passes away, for example, it can result in an inadvertent termination of the S election. This article will provide some easy recommendations to help maintain your bank’s S corporation status.
To maintain S corporation status, you must comply with the IRS requirements. First, S corporations can have no more than 100 shareholders, although for the purposes of this limit, stock owned by members of a family (common ancestor and all lineal descendants, including spouses and former spouses) is treated as owned by one shareholder. Shareholders also may only be individuals, certain trusts or estates. Partnerships, corporations and non-resident aliens are not eligible shareholders. Thus, if you gain more than 100 shareholders, or if a shareholder passes away and his or her will transfers shares in the bank to a corporation, S corporation status may be terminated. This can create an enormous tax burden on the bank.
In order to protect against inadvertent termination, it is essential to have and review a shareholders’ agreement. A shareholders’ agreement can include transfer restrictions, which give you the ability to buy back shares from departing shareholders in order to prevent a sale or transfer to ineligible shareholders. It can also provide protections such as fee shifting and indemnification in the event that S corporation status is inadvertently terminated, or it can contain a flat prohibition on any sale that voids the S corporation status. If your shareholders’ agreement has not been reviewed recently, it is a good idea to have an attorney review it to confirm it is up to date with current law.
Stock Transfers and Shareholders’ Lists
S corporations should also monitor stock transfers and their shareholders’ list. A robust stock transfer monitoring program will allow you to identify and prevent ineligible transfers before they are made. Additionally, regular review of your shareholders’ list should be done at least annually to confirm all shareholders are eligible. You may consider periodically having your bank’s accountant or attorney perform a detailed review of the shareholders’ list.
Proactive and regular communication with shareholders can also be helpful in preventing ineligible transfers. You may choose to require shareholders to certify they still qualify as eligible shareholders each year, or you may simple remind shareholders about consequences upon death.
It is also important to take precautions to ensure other S corporation requirements are met. S corporations are limited to one class of stock, so distributions should be equal amongst shareholders. In addition, if you have converted to an S corporation from a C corporation, there are certain rules relating to passive investment income. S corporation status may be terminated if the passive investment income limit is exceeded for three consecutive years.
If you do inadvertently lose your S corporation status, the IRS may grant relief and restore S status retroactively. Regulations allow for a waiver of the terminating event on the grounds of inadvertency if certain conditions are met. This process can be cumbersome and expensive, so it is best practice to monitor your S corporation status on the front end in order to prevent inadvertent termination.