IRA Rollovers of S Stock

In Letter Ruling 200122034, the IRS ruled that a rollover of S stock into an IRA does not terminate the corporation's S status if it were to repurchase the stock immediately. In this ruling, XYZ Company maintained an employee stock ownership plan (ESOP) since year 1, under which it established a trust to hold XYZ stock for the ESOP. The trust had acquired all of XYZ's shares by the end of year 2. In addition, by the end of year 2, XYZ elected S status.

Under the ESOP's terms, the plan could make distributions to participants in cash or XYZ stock. However, as long as XYZ remained an S corporation, it would have to immediately purchase any distributed stock. The terms also allowed participants receiving a distribution to roll it over directly into an IRA or other qualified plan as required under Sec. 401(a)(31). Alternatively, a participant who received and sold XYZ stock to XYZ could, within 60 days, roll over the proceeds into an IRA or other qualified plan via an indirect rollover.

In a direct or indirect rollover, a participant or a participant's IRA, qualified-plan custodian or trustee had to complete an irrevocable stock transfer form. The form was prepared specifically for each participant receiving an ESOP distribution and identified the number of shares and the dollar value to be sold to XYZ immediately following the distribution. XYZ prepared a stock certificate and a check for each participant receiving a distribution. Because the stock distribution and corresponding repurchase occurred on the same day, the stock certificate did not leave XYZ's office. As such, XYZ could monitor the timing of stock distributions from the ESOP and ensure that it never exceeded the 75-shareholder limit.

XYZ requested a ruling on whether its S status would terminate if the ESOP made XYZ stock distributions and one or more participants elected to make a direct rollover of the distribution to an IRA, provided XYZ purchased the stock immediately, under the above procedures.

Under Sec. 1361(b)(1)(B), an S corporation may not have a shareholder that is not an estate, a trust described in Sec. 1361(c)(2), an organization described in Sec. 1361(c)(6) or an individual. In addition, Rev. Rul. 92-73 held that an IRA is not a permitted S shareholder. Under Sec. 1361(c)(6), for purposes of Sec. 1361(b)(1)(B), an organization described in Sec. 401(a) or 501(c)(3), and exempt from taxation under Sec. 501(a), may be an S shareholder. An ESOP is an eligible S shareholder under Sec. 1361(c)(6), provided it is described in Sec. 401(a) and is exempt from tax under Sec. 501(a).

Sec. 401(a)(31) requires a Sec. 401(a) plan to allow participants to elect to have an eligible rollover distribution paid directly to an eligible retirement plan specified by the participant. Sec. 402(c)(4) defines the term "eligible rollover distribution" as any distribution to an employee of all or any portion of the balance of his account in a qualified trust, except for distributions made in the form of an annuity or installments over a period of 10 or more years. Under Sec. 402(c)(8)(B), an eligible retirement plan includes an IRA. An ESOP under Sec. 409(h)(1)(A) is generally required to make distributions in the form of employer securities. However, under Sec. 409(h)(2), an ESOP maintained by an S corporation may provide benefits distributed in cash. Sec. 409(h)(2) also provides that benefits from a SESOP may be distributed in the form of employer securities, subject to the requirement that they may be sold back to the employer under a fair valuation formula.

In the ruling, when a stock distribution was rolled into an IRA, the custodian received the proceeds of XYZ's repurchase of the stock rather than the stock itself. As such, a rollover (whether direct or indirect and whether of stock or cash) into an IRA results in the IRA custodian receiving cash on behalf of the plan participant. The IRS ruled that the momentary designation of the IRA custodian as the owner of the stock under these facts did not cause XYZ's S election to terminate. Accordingly, the Service ruled that XYZ's S status would not terminate if the ESOP were to make distributions of XYZ stock and a participant were to elect to make a direct rollover into his IRA, provided that XYZ immediately repurchased the stock under the procedures discussed.

From Brian E. Keller, CPA, Oak Brook, IL