Part I of this post can be found here.
Now that the disgruntled shareholder has decided to transfer his or her shares to an ineligible shareholder, the transferee must be selected, as must the method of transfer.
This is a very critical point in the process because the shareholder must balance two competing desires: on the one hand, the corporation’s loss of its “S” status and its impact upon the majority shareholders, and, on the other hand, the shareholder’s loss of his or her equity.
The transfer must be real and bona fide; it must have economic reality, and must represent a real transfer of beneficial (as well as legal) ownership. It cannot be a mere formal device; if it is, the IRS may disregard it as a sham or otherwise.
Furthermore, a state court may not respect the transfer (e.g., treating it as a breach of a shareholder’s fiduciary duty). However, it is unclear how the IRS and the federal courts would react to that – there have been instances going both ways.
Turning to the nature of the transferee, there are several options to consider.
Transferring to a single member LLC would not work because the shareholder would still be treated as the owner of the stock (unless the LLC elected to be taxed as a corporation).
Transferring to a partnership between the shareholder and his or her spouse could work since a partnership is not a permitted S corp. shareholder. However, if the partnership lacks any other business activity, it may be disregarded as a separate entity; instead, the spouses may be considered as joint-owners of the stock (which is generally permitted for S corps).
A transfer to a revocable trust would not work because revocable trusts are treated as grantor trusts, and the shareholder would continue to be treated as the owner of the shares.
A transfer to an irrevocable trust may work, provided it is structured in a way so as to avoid grantor trust status (though the transfer may result in a taxable gift).
In the case of a transfer to an irrevocable trust, the extent of the trustee’s powers will depend, in part, upon the trustee selected, with an “independent” person allowing for more flexibility without triggering grantor trust status. The shareholder generally cannot act as a trustee and also disqualify the trust as an S corp. shareholder – rather, the trust would likely be treated as a grantor trust, with the shareholder as the deemed owner of the stock.
It is also important to note that whoever the trustee is, he or she may be able (or may be required as a fiduciary) to make tax elections for the trust, including an ESBT election (which would defeat the shareholder’s goal of disqualifying the S corporation).
Most minority shareholders will typically want to eat their cake and have it too. They want to retain control and maximum flexibility over whatever vehicle owns the stock.
That leaves us with a corporation. The shareholder may be the sole shareholder of a newly-formed corporation, and may serve as its sole director and officer.
The new corporation may file its own S election.
A corporation, including an S corporation, cannot hold shares of stock in an S corporation without causing the loss of the latter’s S status.
The transfer of stock to the new corporation will terminate the S corp. election.
It will be important that the new corporation not be a mere nominee for the shareholder’s beneficial ownership of the stock. Rather, it must have economic substance, which may be accomplished by having it acquire other investments.
Certainly, all of the corporate formalities in dealings between the shareholder and the new corporation must be respected.
For the year of the lost election, the S corporation would have to “notify” the IRS of the loss of its status on its tax return. It would file a final S corporation return and an initial, short year C corporation return.
In the event the shareholder comes to a resolution with the majority shareholders, however, it should be possible to rescind the transfer of the stock, meaning the new corporation would return the stock to the shareholder and return him or her to their position as the owner thereof.
This must occur in the year of the “disqualifying” transfer if the shareholder is going to have a chance at arguing that the original transfer should be disregarded for tax purposes. A later return of the stock to the shareholder may be a taxable event as to the shareholder.
In the absence of a resolution, the shareholder can count on the fact that the other shareholders will refuse to notify the IRS, or even sue to void the stock transfer. If they are well-advised, they will seek to attack the disqualifying stock transfer as a sham, as a transfer to a nominee, as a breach of fiduciary duty that should be revoked, etc.
It is difficult to predict the ultimate result. Generally, the minority shareholder is aiming for the threat and for the tax/economic uncertainty it will create for the other shareholders.
What if the majority shareholders ignore the disqualifying transfer?
The minority shareholder may file an IRS Form 8082, “Notice of Inconsistent Treatment,” notifying the IRS that he or she is treating the corporation’s income in a manner that is inconsistent with the Sch. K-1 issued to the shareholder. On that form, the minority shareholder would explain that the S corporation lost its tax status with the transfer of its stock to a non-qualifying shareholder.
The shareholder also may consider alerting the majority shareholders that he or she plans to file the Form 8082 to put the IRS on notice if they do not file a final S corporation return.
There is a lot to digest here, and there are a number of strategic decisions for the disgruntled shareholder to make, preferably in conjunction with his or her litigation and tax counsel.
The better, and ultimately less expensive, course would have been for the shareholders to have entered into well-drafted shareholder agreement at the inception of their relationship. An agreement that addresses distributions, rights of first refusal, put rights, stock valuation, and mechanisms for dispute resolution is priceless.