Updated July 19, 2017
Part I of this blog post detailed the requirements for eligibility for electing S corporation status, maintaining it, as well as the tax benefits of being an S corporation. It also outlined how S corporation status can be lost. The possible loss of S corporation status becomes very tricky when a foreign shareholder is involved, since nonresident aliens are not permitted to be shareholders in an S corporation. If a foreign national is a shareholder and is a US “resident” for income tax purposes, then S corporation status is fine, but it must be remembered that the other shareholders do not have control over the individual’s maintenance of his US “resident” status.
How to Prevent Inadvertent Termination of S Corporation Status
Steps to prevent the inadvertent termination of S corporation status should be undertaken whenever possible. This post will focus on preventing termination due to the S corporation having a nonresident alien shareholder. It is critical that shares of an S corporation are not transferred to an ineligible shareholder, such as a nonresident alien, or that a resident alien shareholder does not later become a nonresident, after the S election has been made. How can this be accomplished as a practical matter?
A shareholders’ agreement can explicitly prohibit transfers of any shares to any person other than a permitted S corporation shareholder. The agreement can also require as a condition to the ownership or transfer of shares, a certification from the transferee as to his eligibility and require an ongoing covenant to maintain that eligibility so long as he remains a shareholder in the S corporation. When a foreign person owns shares, a covenant that he maintain US tax residency while a shareholder can be included in the shareholder agreement.
Sometimes, however, these provisions may not be sufficient. It can happen that a resident shareholder suddenly loses that status through inadvertence or carelessness. While the other shareholders can possibly have recourse against him, the damage will have been done as the S corporation status will have been lost on the occurrence of the disqualifying event. Possible protection from this can take the form of a clause in the shareholder agreement to which the corporation itself would be a party. The clause could specify that a redemption of shares will be deemed to have occurred on the day before the occurrence of the disqualifying event, with the terminated shareholder being paid for his shares at the fair market value on such date.
IRS Relief for Inadvertent Termination of S Corporation Status
If the above mechanisms fail, and the S corporation status is inadvertently terminated, the Internal Revenue Service (IRS) may still grant relief under IRC Section 1362(f). In order to obtain such relief, the corporation must demonstrate that the termination was inadvertent and show that it took steps to correct the situation. In addition, the corporation and all relevant shareholders must agree to make any adjustments the IRS requires that are consistent with the treatment of the corporation as an S corporation.
In recently released Private Letter Ruling, PLR 2017-27001, the IRS permitted a corporation which inadvertently lost its S corporation status to correct the mistake using Section 1362(f). In the ruling, each of three shareholders transferred their S corporation interest to a single member LLC, which is treated for US tax purposes as a “disregarded entity“. This action in itself was not a problem. The disregarded entity is “looked through,” and so long as the owner of the LLC is an eligible person for purposes of being an S corporation owner, the tax status of the underlying S corporation is safe. Unfortunately one of the LLC owners “following the advice of a tax professional” later made an S election over his own LLC disregarded entity, thus changing the status of his LLC from being a disregarded entity to that of an S corporation. This action terminated the S corporation status of the underlying S corporation since it now had a corporate owner, which is prohibited under the S corporation rules! Fortunately, the IRS permitted the corporation to correct this inadvertent mistake, but surely this result was achieved only after significant professional fees and much stress.
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