Controlling the Number or Eligible Shareholders in an S Corporation

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—S Corporations," 15th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8241; www.ppcnet.com).

Facts: Galvin, Inc. is a family-controlled publishing company. The company was formed about 40 years ago by three brothers, who are now quite elderly. The three Galvin brothers, their children, grandchildren and various spouses of the children and grandchildren hold all the stock. The company had always operated as a C corporation, but recently converted to S status. This change has worked well, allowing the corporation to avoid incurring corporate tax before issuing small dividends and allowing the shareholders to receive larger cash distributions without double taxation. • The controller of Galvin, Inc. is concerned that the corporation may be about to exceed the current S corporation limit of 75 shareholders. The controller believes that there are 73 shareholders for eligibility purposes, but has raised the following issues:

1. One of the elderly brothers is terminally ill. According to his will, his stock will pass directly to his surviving spouse, but only after an anticipated two-year period of estate administration. His wife is already a direct shareholder on her own.

2. One of the Galvin grandchildren, Glenda Jones, is about to divorce her husband, Tom; Glenda is a shareholder and Tom is not.

3. Another grandchild, who holds only 10 shares of stock, has suffered severe financial difficulties as part owner of a failed business venture. The grandchild guaranteed a number of business debts and may be forced into bankruptcy.

Recognizing the likelihood that the number of stockholders will continue to increase and present a threat to the corporation's S eligibility, the controller has two suggestions:

1. Form a partnership within each family group to hold its stock, thus reducing the number of shareholders.

2. If a partnership is not viable, use some other conduit entity, such as a simple trust or another S corporation, to serve as a "holding company" shareholder.

Issue: Can Galvin, Inc. maintain its S status eligibility (in terms of staying within the 75-shareholder limit), given the various changes in stockholder circumstances?

Analysis

The corporation's tax adviser should first verify the controller's determination that the current shareholder count is 73. For the 75-shareholder limit, a husband and wife are counted as one shareholder. (This rule applies whether the spouses hold stock individually or jointly.) After verifying the shareholder count, the tax adviser should address each issue facing the corporation.

Stock Passing to an Estate

The terminally ill brother and his wife are currently counted as one shareholder. On his death and the passage of his stock into his estate, the surviving spouse and the estate will still be considered one shareholder. On the termination of the estate and the transfer of the stock to the surviving spouse, she will hold all shares as an individual. There is no time limit restricting the eligibility of an estate as an S shareholder, although it may have to justify its continued existence beyond two years on Form 1041, U.S. Income Tax Return for Estates and Trusts. Once sufficient time has elapsed for the executor to wrap up all the administrative duties, the IRS may deem an estate to be a trust. This determination will depend on all the relevant facts and circumstances. Reclassification of an estate as a trust could have a serious adverse impact on the continued S corporation eligibility if the Service determines the trust to be an ineligible shareholder.

There is a related problem not present in the Galvin, Inc. scenario. If the stock were transferred from the estate to a testamentary trust (rather than directly to the surviving spouse), an additional shareholder would be created and could eventually jeopardize the S election, because testamentary trusts are permitted as S shareholders for only a two-year period.

Stock Transferred in Divorce

Tom may receive part of Glenda's stock when their marital property is divided in the divorce. If stock ownership were split as a result of divorce, the former spouses would be counted as two for the S-shareholder limit. Accordingly, the controller might want to contact Glenda Jones and her attorney, suggesting that an effort be made in the negotiations to allow Glenda to retain all Galvin, Inc. stock. If this is not feasible, the corporation might consider offering to redeem any stock that Tom receives.

Stock Transferred to Estate in Bankruptcy

Stock in the hands of an individual's bankruptcy estate is considered owned by an eligible shareholder. Also, the mere transfer to the bankruptcy trustee does not increase the number of shareholders. Eventually, however, the bankruptcy estate would probably attempt to convert the shares of Galvin, Inc. to cash, which could lead to an expansion of the shareholder group.

Use of Partnership or Other Conduit as S Shareholder

Use of partnerships. Forming a family partnership to minimize the number of shareholders is not feasible. Stock owned by a partnership leads to direct disqualification of S status. The partnership is considered the shareholder, and partnerships are not eligible to hold S stock.

Use of trusts. While certain trusts are permitted to be S shareholders, use of a trust as a stockholder for multiple beneficiaries will not decrease the number of S shareholders. A qualified subchapter S trust can have only one beneficiary at a time, although successive beneficiaries can be designated. Another alternative is a Sec. 678 trust, which is a type of grantor trust in which someone other than the grantor is treated as the trust's owner. This one person (the deemed owner) must have the power to vest all trust income and corpus in himself. While multiple beneficiaries are possible with a Sec. 678 trust, the deemed owner has the absolute power to determine who receives distributions of income or corpus. A third alternative might be an electing small business trust (ESBT). If an ESBT is used, each potential current beneficiary is counted as a shareholder. Finally, if a voting trust is used, each beneficiary is counted as an S shareholder.

Stock redemption agreement. To help control the number of shareholders, the corporation and its shareholders should consider adopting a shareholders' agreement. This agreement would contain a buy/sell clause, requiring any shareholder to offer stock either to existing shareholders or the corporation before the shares could be sold, given or otherwise transferred. Because of the large number of shareholders presently owning stock, it is probably more practical to focus on the redemption structure (as offering proportionate purchase rights to 72 other individual shareholders may not be practical).

If a redemption format is used and the corporation has accumulated earnings and profits, the tax adviser should warn the shareholders about the dividend risk that accompanies even a complete redemption if other family members continue to hold corporate stock. However, this risk can be eliminated by using the waiver-of-attribution rules of Sec. 302(c)(2)(A)(iii).

Conclusion

Galvin, Inc. will not exceed the 75-shareholder limit based on the proposed transactions:

1. The stock passing into an estate will not negate the benefit of considering the stock held by a husband and wife as being held by one shareholder. However, the tax adviser should make the family aware of the risk of using such stock to fund a testamentary trust (an eligible S shareholder for only a two-year period).

2. The divorce of the grandchild could add a shareholder, but at that point, Galvin, Inc. would have 74 shareholders and would still be allowed one additional owner.

3. An individual's bankruptcy estate is an eligible shareholder and will not immediately cause an increase in the number of shareholders. Eventual disposition by the bankruptcy estate, however, could expand this number beyond 75.

Of greater long-term importance is shareholder awareness of the consequences of S termination due to an increased number of owners. The tax adviser should explain to the shareholders the merits of establishing a buy/sell agreement to facilitate control of the stock ownership. This would also provide an established mechanism for the sale of stock by those family members desiring to redeem their stock.