Taxing Lessons Case Summaries

Case — Subchapter S Corporation Eligible Shareholder

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TL Case Summ

THE QUESTION

Does having a Roth IRA as a shareholder in an S corporation invalidate the subchapter S election?

THE DISPUTE

Taxpayer Says: A Roth IRA is an eligible shareholder. The company’s status as a Subchapter S corporation remains intact.

Internal Revenue Service Says: The corporation’s status is revoked because a Roth IRA is not an eligible shareholder.

THE LAW

From Internal Revenue Code Section 1361(a), 1362(a)(1): A qualifying “small business corporation” must affirmatively elect S corporation status in order to be treated as an S corporation for federal income tax purposes.

From Internal Revenue Code Section 1362(d)(2): An S election terminates automatically and immediately if any of the eligibility rules are violated.

From Internal Revenue Code Section 1362(d)(2)(B): If an ineligible shareholder acquires stock in an S corporation, the S corporation’s S election terminates on the date on which the ineligible shareholder acquired the stock.

From Internal Revenue Code Section 1361(b)(1)(B), (c)(2), (6): In general, S corporation shareholder eligibility is limited to domestic individuals, estates, certain trusts, and certain exempt organizations.

THE CAUSE OF THE DISPUTE

A subchapter S corporation is a corporation that has elected to be treated as “pass-through” entity for tax purposes, meaning the corporation’s income and expense items are generally passed through to the shareholders instead of being taxed at the corporate level. To maintain S corporation status, a corporation has to follow the requirements in the Internal Revenue code, including restrictions on who can own shares of stock.

Currently, eligible shareholders include US citizens, resident individuals, estates, and certain trusts and tax-exempt organizations. When a shareholder who does not fall into one of these categories acquires stock in a company, S corporation status ends.

In this case (involving the 2003 income tax return of an S corporation) the sole shareholder of the S corporation’s stock was a Roth IRA. The taxpayer says a custodial account qualifying as an IRA also meets the qualifications to be a shareholder of an S corporation, and that the beneficiary of the IRA (the taxpayer) should be considered the shareholder. Alternatively, the taxpayer says the IRA is a grantor trust, which is an eligible S corporation shareholder. Either way, the corporation should retain its S corporation status.

The IRS says the only trusts that can be S corporation shareholders are grantor type trusts, qualified Subchapter S trusts or Electing Small Business trusts. An IRA is not specifically mentioned in the code or regulations, and so is not a trust eligible to be an S corporation shareholder (except in the case of certain S corporation banks). Since the IRA is not an eligible shareholder, the corporation’s S status is revoked for 2003.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 87KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. A Roth IRA is not a qualified S corporation shareholder. The corporation’s S status is revoked for 2003. (NOTE: The tax year in this case was 2003. Federal tax regulation 1.1361-1(h)(1)(vii), effective August 14, 2008, specifically prohibits IRAs from qualifying as eligible S corporation shareholders.)
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