S corporation shareholders must be careful not to inadvertently terminate their closely held company’s S election when engaging in estate planning.
Closely-held entities, which choose not to be formed as a partnership or limited liability corporation, often elect to be taxed as an S corporation under the Internal Revenue Code to avoid the double taxation associated with C corporations. S corporations pass corporate income, losses, deductions and credit through to their shareholders for federal income tax purposes and, therefore, pay no corporate level income taxes.
Subject to certain conditions, individuals, estates and trusts are eligible to hold S corporation shares. If S corporation shares are inadvertently transferred by a shareholder to a non-qualifying shareholder, the S election will terminate and trigger corporate level taxes, which can be disadvantageous to all shareholders. Qualifying trusts are grantor trusts, qualified Subchapter S trusts (“QSSTs”), electing small business trusts (“ESBTs”), testamentary trusts, and voting trusts. Each type of qualifying trust is subject to different and very specific requirements under the Internal Revenue Code, and, therefore, we highly recommend consulting an attorney before transferring shares of an S corporation to a trust.
Unfortunately, we have observed a number of S corporation shareholders (or more frequently their co-owners) inadvertently terminate their company’s S election by transferring shares to a non-qualifying trust. To avoid this result, we recommend that S corporation shareholders enter into or amend existing shareholder agreements to restrict transfers to qualified shareholders, particularly to qualifying trusts, unless such recipient trusts are first reviewed by knowledgeable counsel and deemed eligible to hold S corporation shares.
In addition, we encourage directors and officers of S corporations to carefully monitor shareholder trusts because trusts that at one point in time were eligible to hold S corporation shares later may become ineligible to hold S corporation shares. This change in a trust’s eligibility to hold S corporation shares may be inadvertent and may occur without the knowledge of the directors, officers or other shareholders of the S corporation. For example, a grantor trust is a trust that is treated as owned by an individual for federal income tax purposes under the Internal Revenue Code. If the grantor dies or if the terms of the trust that give rise to grantor trust status are released or waived, the trust may become a non-grantor trust and therefore ineligible to hold S corporation shares unless further action is taken to make the trust eligible as a QSST or ESBT. In the event that S corporation shares nonetheless are transferred to a non-qualifying trust, in certain circumstances, a corporation’s S election may be preserved by following the Internal Revenue Code inadvertent termination relief provisions, but corporations should act promptly to correct a violation if discovered.