Eligibility Requirements, Elections & Terminations

10.1 Eligibility Requirements, Elections & Terminations

Achieving and maintaining S corporation (S corp) status is a powerful strategy for many closely held businesses seeking pass-through tax advantages while retaining certain corporate benefits. However, it is a delicate structure that demands strict adherence to eligibility requirements, vigilant election procedures, and knowledge of how S status can be inadvertently terminated. The material in this section is particularly relevant for the CPA candidate preparing for the Tax Compliance and Planning (TCP) portion of the Uniform CPA Examination. A sound grasp of these concepts is vital for successfully advising clients and ensuring accurate tax filings.

This section explores the rules governing permissible shareholders, stock classification, election timing requirements, and the procedures (both deliberate and inadvertent) that could terminate S corporation status. We will also highlight best practices, practical examples, and real-world scenarios that illustrate the complexities of maintaining S corporation status.

Overview of S Corporations

S corporations combine the limited liability of a C corporation with pass-through tax treatment more akin to partnerships. Instead of the entity itself paying tax on corporate earnings, S corporations pass their income, losses, deductions, and credits through to shareholders. Shareholders then report these items on their personal tax returns in proportion to their ownership interest. To enjoy these benefits, a corporation must meet stringent requirements under Subchapter S of the Internal Revenue Code (IRC §§1361–1379).

While straightforward in theory, an S corporation must remain compliant with a unique set of laws and regulations. Any misstep–such as inadvertently having an ineligible shareholder or issuing a second class of stock–threatens termination of the S status. This section details how to prevent such pitfalls and how to address them if they occur.

Permissible Shareholders

Under IRC §1361(b)(1), an S corporation can only have certain types of shareholders. Failure to comply can result in immediate loss of S status. The following categories of shareholders are permitted:

• U.S. Citizens or Resident Individuals: Typically, shareholders must be either U.S. citizens or resident aliens (i.e., individuals classified as residents for U.S. tax purposes). Nonresident aliens are not allowed.

• Estates and Certain Trusts: Estates of deceased shareholders can hold stock in an S corporation. Specific trusts—such as Grantor Trusts, Qualified Subchapter S Trusts (QSSTs), and Electing Small Business Trusts (ESBTs)—are permitted to own S corporation stock. Each type of trust must meet specialized conditions; for instance, a QSST requires that there be only one income beneficiary during the life of the trust.

• Single-Member LLCs (Disregarded Entities): The IRS generally allows an LLC with a single eligible member to hold S corp stock, as the LLC is treated as a disregarded entity. However, if the single-member LLC has any multi-owner characteristics, it risks introducing impermissible members.

• Charitable Organizations and Certain Exempt Entities: Certain §501(c)(3) organizations and Employee Stock Ownership Plans (ESOPs) are permissible shareholders. However, the S corporation must monitor ownership percentages and organizational structures to ensure tax-exempt compliance.

Prohibited Shareholders

Any corporation or partnership (other than a single-member LLC treated as a disregarded entity) cannot hold stock in an S corp. Likewise, foreign (nonresident alien) shareholders disqualify the entity for S status.

It is crucial for a tax advisor to verify that all shareholders, at all times, remain within desired ownership categories. Inadvertently transferring—or bequeathing—stock to an ineligible shareholder immediately jeopardizes S status.

Stock Classification: Single Class Requirement

Another cornerstone of S corporation eligibility is its single class of stock requirement (IRC §1361(b)(1)(D)). An S corporation must issue only one class of stock, although different voting rights (e.g., voting vs. nonvoting) are permissible as long as all other economic rights—distributions and liquidation preferences—remain the same across shares.

Identifying a Second Class of Stock

A second class of stock can arise, for example, if certain shareholders receive preferential distribution rights. Common pitfalls include:

• Disproportionate Distributions: If one group of shareholders repeatedly receives larger or different distributions than others, this can be interpreted as a second class of stock.
• Shareholder Agreements: If shareholder agreements grant special rights or preferences related to dividends or liquidation, the IRS may deem that the corporation has created more than one class of stock.
• Convertible Instruments: Certain convertible debt or equity can inadvertently produce a second class of stock if the instrument is effectively equity-like in nature.

To remain compliant, confirm that all issuance documents, shareholder agreements, and corporate bylaws dictate uniform economic rights among shares. Voting differences alone are allowed, but watch out for any arrangement that provides special privileges or economic benefits to a select subset of owners.

Maximum Number of Shareholders

An S corporation is limited to 100 shareholders (IRC §1361(b)(1)(A)). For counting purposes, members of the same family can elect to be treated as a single shareholder under the family aggregation rule. However, even with family aggregation, the total permissible count is not indefinite. A simple miscalculation or oversight (e.g., a partial sale of shares creating multiple owners from different branches of a family) can trigger a breach of the 100-shareholder threshold. Meticulous record-keeping and communication with existing and potential shareholders are essential.

Making the S Election

To become an S corporation, an eligible entity must make a valid election on Form 2553, “Election by a Small Business Corporation,” with the IRS. The corporation must already be formed as a C corporation (default classification) or, in limited cases, as an LLC that elects to be taxed as a corporation. The S election then transitions the taxed status from C corp to S corp.

Timing Requirements

Generally, for the S election to be effective for the current tax year, the corporation must file Form 2553 no later than the 15th day of the third month of the tax year. For a calendar-year corporation, this deadline typically falls on March 15. If the entity is formed mid-year and seeks S corporation status immediately, Form 2553 must be filed within 75 days of formation (or of the beginning of the tax year in which S status is desired).

If the deadline is missed, late election relief may be available under certain Revenue Procedures (e.g., Rev. Proc. 2013-30). The corporation must show there was “reasonable cause” for not making a timely election and that it always acted as an S corporation (e.g., maintained a single class of stock and allocated income according to pro rata ownership).

The timeline below depicts a general overview of the election process:

    flowchart LR
	    A[Form Corporation] --> B[Check Eligibility Requirements]
	    B --> C[File Form 2553 <br/> Before 15th Day of 3rd Month]
	    C --> D[S Election Becomes Effective]

Key Components of Form 2553

• Basic Corporate Information: Name, address, EIN, and state of incorporation
• Shareholder Consents: All shareholders must consent to the S election, typically by signing the form or relevant attachments
• Effective Date Selection: Indicate the tax year and start date for desired S status
• Fiscal Year Data: If the corporation wants a fiscal year instead of a calendar year, additional justification is required under IRC §444 or related regulations

Addressing LLCs Electing S Status

For an LLC desiring S corp status, the LLC must first elect to be treated as a corporation for federal tax purposes (using Form 8832), then timely file Form 2553 for the S election. Proper sequencing ensures the LLC’s classification as a corporation is recognized, and from there it can qualify for S status if all other eligibility criteria are met.

How S Status Is Terminated

Terminating an S corporation election, whether deliberate or inadvertent, triggers the corporation’s return to C corporation status (or, in some cases, to another classification, such as a partnership if the entity fails corporate classification tests). Common termination pathways include:

1. Voluntary Revocation: An S corp can voluntarily revoke its election by filing a Statement of Revocation with the IRS. Such a revocation generally requires the consent of more than 50% of the shares. The revocation can be set to be effective on a certain date if desired.

2. Failure to Meet Eligibility Requirements: Entering into a prohibited shareholder arrangement or issuing a second class of stock results in immediate termination. This unintended termination often occurs without the corporation’s realization. Once discovered, the corporation must address the problem retroactively if possible or accept that the election was lost.

3. Exceeding the 100-Shareholder Cap: If the number of shareholders surpasses 100, the S election terminates automatically effective on the date the threshold was exceeded.

4. Passive Investment Income in Excess of Limits (for Former C Corps): If the entity has accumulated earnings and profits (E&P) carried over from its C corporation history and realizes excessive passive investment income over three consecutive years, its status may be terminated. Passive investment income includes interest, dividends, rents, and royalties. The corporation must distribute E&P or restructure activities to avoid exceeding statutory thresholds.

Rescinding and Reinstating S Status

Inadvertent terminations may be mitigated if the IRS determines that:

• The termination or invalid election was due to an unintentional error.
• Reasonable steps were taken to correct the error once discovered.
• The entity and its shareholders have always acted as if the corporation remained an S corporation.

In these cases, the IRS can issue a letter ruling granting relief under IRC §1362(f). If relief is granted, the corporation is treated as if its S election never terminated. The corporation must correct the issue (e.g., rectify shareholder eligibility, fix the second class of stock problem) and adopt measures to prevent future errors.

Managing and Preventing Accidental Terminations

Below are strategies to reduce the likelihood of losing S status:

• Regular Ownership Audits: Keep thorough records of shareholder demographics. This includes monitoring for any ownership changes that might inadvertently introduce an ineligible shareholder (e.g., a foreign individual or a partnership).

• Careful Document Drafting: Review shareholder agreements, corporate bylaws, and convertible instruments to guarantee compliance with the single class of stock requirement.

• Educating Shareholders: Ensure all current and prospective shareholders understand the constraints of S corporation ownership to prevent unauthorized share transfers.

• Communications with Trust Entities: If a trust is involved, work closely with the trustee to ensure that it qualifies under QSST or ESBT rules if needed.

• Timely IRS Filings: Track deadlines meticulously. Utilize late election relief options only when absolutely necessary and with thorough documentation of reasonable cause.

• Monitoring Passive Investment Income: For corporations with C corporation E&P, keep an eye on potential triggers for termination due to excessive passive investment income over three consecutive years.

Practical Example: Family Business Transition

Consider a family business, “Oak & Pine Carpentry, Inc.,” that transitions from a father and mother as sole shareholders to including their adult children. Initially, Oak & Pine qualifies as an S corporation: only two shareholders, both are U.S. citizens, a single class of stock, and timely election. Eventually, one child invests. Now there are three shareholders–still fine and under the 100 limit. Over the years, each sibling invests, and the father places some shares in trust for his grandchildren.

To manage these expansions:

• The father must ensure that the trust for his grandchildren meets the QSST or ESBT guidelines.
• The new shareholders must sign updated documents confirming no second class of stock is created.
• The S corp election must remain in good standing, verifying that no disallowed entity has been introduced.

If the father had established a trust that did not qualify as a QSST or ESBT, this oversight would lead to immediate termination. Oak & Pine would be forced to operate as a C corporation from the date of the ineligible transfer unless it secured inadvertent termination relief.

Real-World Scenario: Unintentional Foreign Shareholder

A prime example of an inadvertent termination is when a shareholder relocates and becomes a nonresident alien or transfers shares to a foreign relative. This could happen in the context of an inheritance or relocation for work. Suppose the shareholder fails to inform the corporation of their change in tax residency. Because nonresident aliens are ineligible S corp shareholders, the S election terminates automatically on the date that status changed. If discovered within a reasonable time and corrected, the corporation may request an IRS letter ruling for relief under IRC §1362(f). However, it must demonstrate that the termination was unintentional and all parties continued operating as though S status were intact.

Best Practices and Strategies

• Periodic Legal and Tax Compliance Checkups: At year-end or quarterly intervals, tax advisors and management should review eligibility criteria.
• Draft Comprehensive Shareholder Agreements: Provisions should explicitly prohibit the transfer of shares to ineligible entities.
• Use Reminders for Corporate Filings: Proper calendaring of deadlines for Form 2553, annual state filings, and other corporate filings can prevent missed elections or late adjustments.
• Preventing Multiple Classes of Stock: If issuing voting and nonvoting shares, confirm they are identical in all economic terms.
• Family Aggregation Monitoring: Understand how the family aggregation rules can affect the 100-shareholder count.
• Document All Corrections: If a potential issue surfaces, keep a clear paper trail of steps taken to rectify it.

Diagram of Key Factors Affecting S Corporation Status

Below is a high-level illustration of the common factors that impact S corporation status. Each node can cause or maintain S status, depending on whether it is properly managed.

    flowchart TB
	    Start((Start as S Corp)) --> Ownership[Shareholders <br/> (Individuals, Estates, Trusts)]
	    Ownership --> StockStructure[One Class of Stock <br/> (Common / Nonvoting)]
	    StockStructure --> Eligible[Maintain S Status]
	    StockStructure --> Ineligible[Another Class? <br/> Termination]
	    Ownership --> 100Cap[Under 100 Shareholders?]
	    100Cap --> Eligible
	    100Cap --> Ineligible[Over 100 <br/> Termination]
	    Ownership --> ForeignHolder[Foreign or Ineligible Holder?]
	    ForeignHolder --> Ineligible
	    Eligible --> PassiveIncome[Excess Passive Income <br/> (If E&P exists)?]
	    PassiveIncome --> Ineligible[3 Consecutive Yrs <br/> Termination]
	    PassiveIncome --> Eligible[Below Threshold]

Conclusion

Mastering the intricacies of S corporation eligibility, making a timely election, and preventing inadvertent termination is paramount for CPAs tasked with guiding business entities. The S corporation structure, while beneficial, demands ongoing diligence regarding ownership composition, share issuance, and annual governance. A single misstep—be it an improper transfer of stock or the creation of a second class of stock—may jeopardize the tax advantages that accompany S status.

By understanding the eligibility rules, adhering to Form 2553 timing requirements, and monitoring common pitfalls, you will be well-prepared to assist clients in sustaining S corporation status while minimizing the risk of costly reclassifications. Stay alert to subtle changes in residency, trust compliance, or ownership that can terminate S corp status. The next sections will delve further into other complexities specific to S corporations, such as shareholder basis, distributions, and the built-in gains tax, and how each topic weaves into overall tax compliance and planning strategies.

S Corporation Eligibility, Elections & Terminations Knowledge Check

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