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Small Business Corporation
Must be a Domestic Corporation
Can’t be an Ineligible Corporation
Can’t Have More Than 100 Shareholders
Can Only Have Individual Shareholders Except for Certain Trusts
Can’t Have Nonresident Alien as a Shareholder
Can’t Have More Than One Type of Stock
S Corporation Status
Only “small business corporations” may elect to be treated as S corporations. A small business company is defined as a domestic corporation (see later discussion) that meets the following eligibility requirements.
Number of Shareholders
Formerly, S corporations could not have more than 35 shareholders with any of them being nonresident aliens (§1361(b)(1)(A)). The maximum number of S corporation shareholders has now increased to 100. Spouses are treated as a single shareholder (§1361(c)(1)). However, in the event of divorce, if both the former husband and the former wife continue to own shares in the corporation, they will be treated as two shareholders.
It may have only individuals as shareholders. As a result, S corporation shareholders should particularly be advised to enter into a buy-sell agreement that restricts transfers to ineligible persons. However, there are some omissions to this requirement (§1361(b)(1)(B)).
A decedent’s estate or the estate of an individual in bankruptcy may be a shareholder (§1361(b)(1)(B)).
Note: In the case of a testamentary trust or a pour-over type trust, where the stock is transferred into a trust. Under the terms of a will, the decedents’ estate will be considered as the owner of the stock until it is transferred into the trust, at which time the trust may be treated as the shareholder for 60 days.
A trust, all the income of which is taxed to the grantor or to a third party who has control over the trust (i.e., the “deemed owner”), can be a shareholder for 60 days after the death of the deemed owner. If the income of the trust is includible in the gross estate of the deemed owner, the trust can remain a shareholder for two years after the death of the deemed owner (§ 1361(c)(2)(A)(i) and (ii)). Effective for taxable periods beginning after December 31, 1996, the 60-day post-death holding period is increased to two years for all grantor trusts (§1361(c)(2)(A)(i) and (ii)).
A voting trust can be a shareholder. A voting trust is a trust created to exercise the stock voting powers transferred to it. The beneficiaries of the voting trust are counted for purposes of complying with the 100 shareholder rule (§1361(c)(2)(A)(vi)). Do not count the trust itself as a shareholder.
A testamentary trust can be a shareholder for a 60-day period starting on the day the stock is transferred (§1361(c)(2)(A)(iii)). A testamentary trust is created by and receives stock under a will. Effective for taxable years beginning after December 31, 1996, the 60-day post-death holding period is increased to two years for all testamentary trusts.
Qualifying Simple Trusts
A “qualified subchapter S trust” can be a shareholder if the income beneficiary so elects (the election is irrevocable). The beneficiary will then be treated as the shareholder, and the trust will be ignored (§1361(d)). Among other requirements, the trust instrument must provide that all trust income be distributed currently to one individual (who must be a U.S. citizen or resident) and that corpus can be distributed only to that individual (§1361(d)). While only one income beneficiary is allowed, there is no restriction on the number of remainder beneficiaries.
Electing Small Business Trusts
Effective for taxable years beginning later than December 31, 1996, an “electing small business trust” can hold stock in an S corporation (§1361(c)(2)(A)(v)). To qualify:
(1) All trust beneficiaries must be individuals or eligible estates;
Note: However, a charitable organization may hold a contingent remainder interest.
(2) No trust interest can be acquired by purchase; and
Note: Purchase means any acquisition of property with a cost basis determined under §1012. Thus, an interest in the trust must be acquired by gift, bequest, etc
(3) The trust must elect to be treated as an electing small business trust (§1361(e)).
The selection is made by the trustee and applies to the taxable year of the trust for which all subsequent taxable years of the trust unless revoked with the consent of the IRS (§1361(e)(3)).
Each potential current trust beneficiary is counted as a shareholder under the 100-shareholder limitation (§1361(c)(2)(B)(v)).
Note: A potential current income beneficiary is any person who is entitled to a distribution from the principal or income of the trust (§1361(e)(2)).
The portion of the trust that consists of S corporation stock is treated as a separate trust. The trust is taxed at the highest individual rate (39.9% on ordinary income and 28% on net capital gains) on this portion of the trust’s income (§641(a)). No deduction is permitted for amounts distributed to beneficiaries. Also, this income is not included in the distributable net income of the trust and thus is not included in the beneficiaries’ income.
Note: The net effect of this provision is to create a 39.6% penalty for this type of trust. In general, taxpayers would be better served by taking advantage of the two-year holding period available to the grantor and testamentary trusts.
Non-resident aliens may not be shareholders (§1361(b)(1)).
A C corporation is not allowed to be a shareholder in an S corporation.
Effective for taxable years beginning at January 1, 1997, tax-exempt organizations described in §401(a) and §501(c)(3) are permitted to be S corporation shareholders (§1361(c)(7)). In counting the number of permitted shareholders, a qualified tax-exempt shareholder counts as one shareholder. However, income and loss of an S corporation will flow-through to qualified tax-exempt shareholders as an unrelated business taxable benefit, regardless of the source or nature of such income. Thus, for example, the passive income of an S corporation will flow through to a tax-exempt shareholder as UBTI. Benefit or loss on the sale of S corporation stock will also be treated as UBTI.
Exception for S Corporation ESOP – §512
The TRA ‘97 repealed the provision treating items of gain or loss of an S corporation as unrelated business taxable income of an employee stock ownership plan that is an S corporation stockholder. The repeal of such provision applies only concerning employer securities held by an employee stock ownership plan (as defined in §4975(e)(7)) maintained by an S corporation. Critics held by an employee stock ownership plan (as defined in §4975(e)(7)) maintained by an S corporation. 9-9
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