During the course of my career, I have sometimes gone months, if not years, without encountering a particular tax issue. I am aware of the issue and I am familiar with the relevant authorities, but it was not a concern for the clients whom I was then representing. Then, all of a sudden, the issue appears with a frequency that is simply uncanny. I am sure that many of you have had the same experience.

One such issue is the ownership by a nonresident alien (“NRA”) of shares of stock in an S corporation. Specifically, if such an individual owns shares of stock in a domestic corporation, the corporation is not eligible to elect to be treated as an S corporation for tax purposes. Rather, it will be treated as a C corporation, the taxable income of which is taxed at the corporate level and, then again, at the shareholder level when the after-corporate-tax income is distributed to such shareholders.

The prohibition, under the S corporation rules, against stock ownership by an NRA is so basic that you may ask, how can a corporation have knowingly issued shares to an NRA, or how can a shareholder have knowingly transferred his or her S corporation shares to such an individual?

The answer is, “pretty easily,” much to the regret of the other shareholders.

The context in which I recently confronted the issue was the proposed sale of assets by an S corporation, which proposed sale was preceded by the testamentary transfer of a deceased shareholder’s shares of S corporation stock to a trust for the benefit of individuals that included one or more NRAs.


The estate of a deceased shareholder who was a U.S. citizen or resident may own S corporation shares, even where an NRA is a beneficiary of the estate, but only for a reasonable period of administration. If the administration of the estate is unduly or unreasonably prolonged, the estate may, instead, be treated as a trust for income tax purposes. In that case, the rules described immediately below must be considered.

 Section 645 Electing Trust

In the case of a qualified revocable trust for which a timely election is made to treat the trust as part of the decedent’s estate for income tax purposes,  the trust may continue to own the deceased grantor’s S corporation shares for the duration of the so-called “section 645 election period” (generally, the date on which both the related estate and the trust have distributed all of their assets, though the trust’s qualification may end sooner ), even where an NRA is a beneficiary of the trust. At the end of such period, if the trust continues to hold the stock, it may be treated as a testamentary trust for a two-year period (see immediately below).

Testamentary Trusts

A domestic trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will may hold the S corporation stock, but only for the 2-year period beginning on the day the stock is transferred to the trust, even where an NRA is a beneficiary of the trust. After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

Former Grantor Trusts

A domestic grantor trust is a trust, all of which is treated, for tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.

Upon the death of the deemed owner of the grantor trust, if the trust was a grantor trust immediately before the death, and it continues in existence after the death, the trust may continue to hold S corporation stock, even where an NRA is a beneficiary of the trust, but only for the 2-year period beginning on the day of the deemed owner’s death. In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.  After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.


A QSST is a permitted S corporation shareholder. It is defined as a trust that, among other things,  distributes or is required to distribute  all of its income to a citizen or resident of the United States. Thus, a QSST cannot have an NRA as its income beneficiary.  Of course, the NRA cannot be the remainderman.


An ESBT is a permitted S corporation shareholder if it satisfies various requirements, including the requirement that an NRA cannot be a “potential current beneficiary” of the trust.  Thus, an NRA cannot be a beneficiary who is entitled to, or in the discretion of the trustee may, receive, a distribution of principal or income of the trust.

What To Do? Consequences?

OK, an S corporation shareholder has died and his or her shares of stock in the corporation are set to pass to or for the benefit of an NRA under the terms of the decedent’s will or trust.

In the case of (i) an estate, (ii) a testamentary trust, (iii) a former grantor trust, or (iv) a Section 645 trust, the corporation will have some time to consider its options. There aren’t many. At the end of the day, if the corporation is to retain its status as an S corporation, the NRA’s interest will have to be eliminated.

Of course, the foregoing assumes that the corporation and the other shareholders are aware of the NRA’s beneficial interest. What if they become aware of this interest only after the offending transfer has occurred?

At that point, the S corporation will have lost its tax-favored status, becoming a C corporation, the income of which is subject to so-called “double taxation.”  If the corporation desires to re-elect S corporation status, it will generally have to wait five years before doing so. When the “new” S election is made, the corporation will begin a new built-in gain recognition period.

IRS Ruling?

Alternatively, depending on the facts and circumstances, the corporation may be able to request a determination from the IRS that the termination of its election was inadvertent. The request is made in the form of a ruling request and should set forth all relevant facts pertaining to the event or circumstance, including a detailed explanation of the event or circumstance causing the termination, when and how the event or circumstance was discovered, and the steps taken after discovery of the terminating event so as to “correct” the terminating event in order that the corporation may again qualify as a small business corporation.

The corporation has the burden of establishing that, under the relevant facts and circumstances, the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination of the election was inadvertent.

The status of the corporation after the terminating event and before the determination of inadvertence is determined by the IRS. Inadvertent termination relief may be granted retroactively for all years for which the terminating event is effective, in which case the corporation is treated as if its election had not terminated. The IRS may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the IRS. In the case of stock held by an ineligible shareholder (for example, an NRA) that causes an inadvertent termination, the IRS may require the ineligible shareholder to be treated as a shareholder of the S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the IRS may require protective adjustments that prevent the loss of any revenue due to the holding of stock by an ineligible shareholder (for example, an NRA).

Although the IRS may ultimately issue a favorable ruling, including retroactive relief, to redress the inadvertent termination of an S corporation’s election, it would behoove the corporation and its eligible shareholders to avoid finding themselves in the position where such action is required. The best way to do that is to adopt a shareholders agreement that, among other things, prohibits the transfer of stock to an ineligible shareholder, requires shareholders (and their transferees) to make whatever elections are necessary to preserve the Corporation’s status as an S corporation, requires shareholders to cooperate in restoring the corporation’s “S” election, requires shareholders to make their estate plans known to the corporation, and imposes economic penalties upon any shareholder who violates the foregoing provisions, including the cost of any IRS ruling request that become necessary as a result of such violation.