• IRS Issues Guidance on S Corporation Family Shareholder Election
  • December 5, 2005 | Authors: Douglas W. Charnas; Robert G. McElroy; Thomas P. Rohman
  • Law Firms: McGuireWoods LLP - Washington Office ; McGuireWoods LLP - Richmond Office
  • The American Jobs Creation Act ("Act") expanded significantly the number of persons that may hold stock in an S Corporation. In addition to increasing the shareholder limit from 75 to 100, the Act allows members of a family to elect treatment as a single S Corporation shareholder.

    The "family election" was applauded by closely-held business owners, as it greatly expands the number of family members who can hold stock in an S Corporation (or the number of beneficiaries of a family trust that holds stock in an S Corporation). The election also permits owners of widely-held second and third generation family businesses (that previously were unable to make an S Corporation election because of the 75 shareholder limitation) to now make an S Corporation election -- and thus obtain the benefits of this tax-advantaged form of business.

    On November 22, 2005, the Internal Revenue Service ("IRS") issued Notice 2005-91, which provides interim guidance on the family shareholder election until IRS's planned future guidance is issued. The election for existing S Corporations may be made for any taxable year of the corporation beginning after December 31, 2004.

    Owners of closely-held C Corporations (that now may be eligible to make an S Corporation election) should promptly discuss the benefits of an S Corporation conversion with their tax and legal advisors. For an S Corporation election to be effective January 1, 2006, for a calendar year corporation, the corporation must file IRS Form 2553 (Election by a Small Business Corporation) with the IRS by March 15, 2006. Because of the issues to consider before making an S Corporation election, such owners are encouraged to speak with their advisors as quickly as possible.

    Guidance Provided in Notice 2005-91

    Under Notice 2005-91, any member of a family who is (or is treated under Section 1361 of the Internal Revenue Code ("Code") or the regulations thereunder as) a shareholder of the S Corporation may make the election. The election is made by providing written notice to the S Corporation (but not the IRS) to which it applies containing the following information: (1) identification by name of the member of the family making the election; (2) the "common ancestor" of the family to which the election applies; and (3) the first taxable year of the corporation to which the election applies. Although no information is provided to the IRS regarding the election, Notice 2005-91 notes that the corporation is required to keep records in accordance with Code Section 6001 and the regulations thereunder.

    The term "members of a family" is defined in Code Section 1361(c)(1)(B) to include (1) the common ancestor, (2) lineal descendants of the common ancestor, and (3) spouses (or former spouses) of the lineal descendants or the common ancestor. The common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be members of the common ancestor's family (but for the six-generation limit for defining the common ancestor.) This test is applied as of the later of the effective date of the family shareholder rule (taxable years beginning after December 31, 2004), or the time the S Corporation election is made.

    The common ancestor for determining members of a family can be alive or dead at the time the family shareholder election is made. Thus, the family member making the election can determine which six generations will determine the family. Presumably, no one would identify an individual as a common ancestor unless there were living shareholders in that individual's generation. In identifying the common ancestor, any spouse or former spouse of the common ancestor will be treated as being in the same generation as the common ancestor, and any spouse or former spouse of a lineal descendant of the common ancestor will be treated as being in the same generation as the lineal descendant to whom that spouse is or was married.

    The Notice provides the following guidance on when an estate, a trust, a beneficiary of a trust, or a disregarded entity will be considered a member of a family:

    • The estate of a deceased member of a family will be considered to be a member of the family during the period in which the estate, or a trust that received the S Corporation stock pursuant to the terms of the deceased member's will (a trust described in Code Section 1361(c)(2)(A)(iii)), holds stock in the S Corporation.

    • Each potential current beneficiary of an electing small business trust ("ESBT") who is a member of the family.

    • The income beneficiary of a qualified subchapter S trust ("QSST") who makes the QSST election, if that income beneficiary is a member of a family.

    • Each beneficiary of a trust who is a member of the family, if the trust was created primarily to exercise the voting power of stock transferred to it.

    • In the case of a corporation that is a bank (as defined in Code Section 581), the member of the family for whose benefit a trust that constitutes an individual retirement account and meets certain requirements (a trust described in Code Section 1361(c)(2)(A)(vi)) was created.

    • The deemed owner of a grantor trust (a trust treated as wholly owned under Subpart E of Part I of Subchapter J of Chapter 1 of Subtitle A of the Code), if that deemed owner is a member of the family.

    • The owner of a disregarded entity (an entity disregarded from its owner under §301.7701-3 of the Procedure and Administrative Regulations), if that owner is a member of the family.

    The Notice anticipates multiple family elections for an S Corporation in which family members overlap, and provides a taxpayer-favorable rule. If a corporation has two or more elections in effect and the members of one family for which the election has been made (the inclusive family) include all the members of another family for which the election has been made (the subsumed family), then the members of the inclusive family will be counted as one shareholder for purposes of the shareholder limit as long as the inclusive family's election is in effect, and the members of the subsumed family will not be counted as a separate and additional shareholder.

    The election will be effective as of the first day of the corporation's taxable year designated by the shareholder making the election. The Notice does not require this election to be made at any specific time. For example, there is no requirement that the election be made by March 15th of a calendar year taxable year for the election to be effective for that entire year. This absence of any guidance on the date by which the election must be made suggests that the election has retroactive effect, regardless of when made. Assume a calendar year S Corporation has more than 100 shareholders without a family shareholder election and 100 or less with a family shareholder election. Assume further that the S Corporation makes an S Corporation election by March 15, 2006, effective January 1, 2006, but no family member has made a family shareholder election. The S Corporation election is defective because the shareholder limit is exceeded. Although not clear, it appears that Notice 2005-91 would permit a family shareholder election to be made at any time to be effective January 1, 2006, thereby curing the defective election. While this might be the correct result under a literal reading of Notice 2005-91, caution would dictate making the family shareholder election no later than March 15, 2006, until further guidance is provided by the IRS.

    The family shareholder election only applies for purposes of counting the number of shareholders for the 100 shareholder limitation. It has no effect on other existing requirements for qualification as an S Corporation. For example, each shareholder must still sign the S Corporation election. Also, each shareholder must qualify as an eligible S Corporation shareholder. A non-resident alien will not qualify as a shareholder, even if he or she is the member of a family for which a family shareholder election has been made.

    Some family shareholder elections have already been made by various forms of notification to the S Corporation or the IRS. For these elections to be effective for taxable years beginning after 2004, taxpayers will need to provide the information described in Notice 2005-91 to the corporation (to the extent not already provided to the corporation).