November 17, 2016 – In 1980, there were roughly 545,000 S corporations filing tax returns in the United States. By 2011, that number was well over 4 million. As S corporations become increasingly popular, it is important to recognize that an S election can be inadvertently terminated. Understanding the ways in which an S corporation can lose the election can help avoid the possibility of double taxation. Discussed below are ten ways in which an S corporation can have the S election revoked, many of which deal with trusts since the rules surrounding trusts as shareholders are complex.
1. Trusts Owned by More Than One Individual
Although grantor trusts are allowed as shareholders of S corporations, they must be owned by a single individual. If over the life of the trust, a beneficiary is added, this would disqualify the trust and cause a revocation of the S election for the corporation. Other situations such as when there is a power for a beneficiary to withdraw contributions can cause a revocation as well.
2. Foreign Trusts
Foreign trusts are excluded from being S corporation shareholders. Revocations of the S election often occur with trusts that were originally U.S. trusts but have since become foreign due to a change in trustee.
3. Nonresident Aliens
For a corporation to qualify for the S election, it must have only eligible shareholders. This means that the shareholders are not considered partnerships, corporations or non-resident aliens. This can be tricky when shareholders who were once resident aliens move out of the country and become non-resident aliens.
4. Nonresident Aliens and ESBT and QSST Elections
The nonresident alien provision not only applies to individuals but also to Electing Small Business Trusts (ESBT) and Qualified Subchapter S Trust (QSST) elections as well. The beneficiary of an ESBT or QSST must meet the requirements for eligible shareholders meaning that they are U.S. residents. If the beneficiary of an otherwise eligible ESBT is a nonresident alien, then the S election would be revoked.
5. Charitable Remainder Trusts (CRT)
Generally, the only trusts allowed as shareholders of S corporations include grantor trusts, QSSTs, and ESBTs. Therefore, if an S corporation were to issue shares to the CRT, it would lose the S corporation status. However, this does not include charitable organizations qualifying for a 501(c)(3) status.
Although IRAs can be treated in a manner similar to trusts, for S corporation purposes, IRAs are not eligible shareholders. Allowable S corporation trusts are taxed on current income while IRAs are taxed on deferred income. Therefore, IRAs are not similar enough to the allowable trusts to be considered an eligible shareholder.
7. Defective Trust Provisions
Trust documents may contain certain provisions that can make a trust an ineligible shareholder. This can happen if the documents provide for a beneficiary to whom trust assets are set to pay estate taxes upon death. The potential beneficiary is still considered a beneficiary, thus the requirements of a single individual beneficiary are not met.
8. Defective Elections
It is important to ensure that the elections are being signed by the proper people. For example, the beneficiary, not the trustee must sign a QSST election, but the trustee would sign for the ESBT election. Also, the grantor of the trust, not the trustee should sign the S election form. Improper signing can result in an ineffective election.
9. Decanting Trusts
If it is decided that a new trust would better meet the client’s needs, the assets can typically be transferred into a new trust. However, if the old trust was an ESBT, a new ESBT election will need to be filed for the new trust. Failure to do so would result in a revocation of the S corporation status.
10. Failure to Make Timely Elections
Timing considerations are important when making elections. For example, the QSST election must be made within two and a half months after the stock transferred. Things get more complicated when considering unexpected situations. For example, a grantor trust may cease to be considered a grantor trust. Therefore, an ESBT or QSST election must be made within the two and a half month period to keep the corporation from losing its S status. Other situations can arise when the grantor or the beneficiary of a QSST dies. These situations must be carefully considered to determine if there is a potential to have the S election revoked.
In some circumstances the S corporation can apply for a waiver of inadvertent termination as a result of a failed timely election. However, many of the inadvertent terminations mentioned above would require a private letter ruling in order to obtain the necessary wavier.
If you are unsure whether or not this applies to you please contact or your Dopkins Tax Advisor for insight, explanation, and assistance.
About the Author
Dopkins Tax Advisory Group
Our tax professionals include specialists who are proactive, strategic thinkers who work to maximize your cash flow. In addition to cash flow considerations, we also believe that tax planning is most effective when it is integrated with, and fully supports, your business plan and personal goals. Our approach to tax planning will help you better understand the tax implications of any proposed course of action, and together we can make the right decisions for your business. For more information, contact Gregory Urban, CPA, CVA at firstname.lastname@example.org.