S Corporations Should Monitor and Track Shareholder Deaths

• March 4, 2020
• Amanda Garnett

As shareholder groups continue to age, we are seeing more S Corporation banks encountering difficult to navigate issues involving shareholder deaths.  S Corporations should remain vigilant to ensure that they don’t put their S Election at risk or cause headaches for the bank or its shareholders. 

Estates as Shareholders

An estate is an eligible S Corporation shareholder and is treated as a member of the shareholder’s “family” for purposes of the 100 shareholder limitation.  During the period of the administration of the estate, there are typically no S Corporation eligibility problems as long as the administration period is not unduly prolonged.   

However, we have seen several situations arise where after a shareholder death the heirs of an estate cannot be located or the shareholder’s family effectively abandons the shares by refusing to respond to inquiries from the bank.  In these situations, management should work with their legal counsel to ensure that the shares are properly transferred or redeemed in accordance with the shareholder agreement and local law. 

Trusts Following Shareholder Deaths

Trusts that remain in effect after the death of a shareholder represent one of the most significant risks for an S Corporation. 

Testamentary trusts, which receive S Corporation stock under the terms of a will are eligible S Corporation shareholders only for a two-year period beginning on the date the stock is transferred to the trust.  To remain an eligible shareholder after this 2 year period, the trust must qualify as either a qualified Subchapter S trust (QSST) or an electing small business trust (ESBT) and make a timely election with the IRS. 

In addition, revocable grantor trusts become irrevocable upon the death of the grantor.  In certain circumstances, the irrevocable trust may not be a qualified trust following death or may be required to make a QSST or ESBT election with the IRS in order to continue to qualify as an S Corporation shareholder.

We’ve seen several situations where QSST and ESBT elections were made late because they were not being actively tracked by management or the shareholder’s family.  If banks are not actively monitoring shareholder deaths, the trusts could become ineligible after a period of time and result in an involuntary termination of the corporation’s S Election.

Involuntary Terminations

In order to qualify as an S Corporation, all shareholders  must be eligible S Corporation owners at all times during the tax year.  If the S Corporation fails to meet the requirements even for a single share of stock, under the tax code, the corporation automatically reverts to a C Corporation and is potentially subject to C Corporation taxes.  This is often referred to as an involuntary termination.  

Involuntary terminations due to ineligible shareholders or late trust elections are relatively common and thankfully can usually be corrected through additional IRS filings.  However, the process can be very costly and time consuming for the bank even if the issue relates to a very small percentage of the corporation’s stock.  And there is always a risk, though rare, that the problem will not be able to be corrected to the IRS’s satisfaction.

Management Due Diligence

There are several things that we recommend that bank’s consider to manage their risks in this area.

• Actively monitor shareholder deaths by subscribing to a death registry service or by some other means so that you are aware of any deaths that occur in your shareholder group and you can work with the shareholder’s heirs to take appropriate action
• Have all trust documents reviewed by an attorney or CPA firm for eligibility prior to transferring shares and upon the death of the grantor, if necessary
• Maintain a shareholder agreement that protects the S Election from involuntary terminations and ensure that all new shareholders sign the agreement before receiving their stock certificates

Next Steps

If you have experienced problems within your shareholder group or are concerned about your S Election, CLA is here to help.  Please contact us. 

Tags: Involuntary Termination, s corporation, Shareholders, tax, Tax Reform | Comments Off on S Corporations Should Monitor and Track Shareholder Deaths