Jonathan R. Katz, a partner in Jones Walker LLP's Tax & Estates Practice Group, presented at the Tulane Tax Institute on October 23, 2015, in New Orleans, Louisiana. Mr. Katz discussed the use of trusts, estates, minors, and others as S corporation shareholders and strategies to protect against direct and indirect transfers to ineligible shareholders. The Tulane Tax Institute presents a forum for attorneys, CPAs, and estate planners to hear nationally recognized tax and estate planning legal practitioners, law professors, and accountants present in-depth reviews of recent tax statutes, regulations and decisions, learn practical tax and estate planning tips, and discuss the current issues impacting their practice.

1. S CORPORATION
SHAREHOLDERS:
PROTECTING WHAT IS NEAR AND DEAR
Presented By:
Jonathan R. Katz
Jones Walker LLP
201 St. Charles Ave., 51st Floor
New Orleans, Louisiana 70170
Phone: (504) 582-8314
Fax: (504) 589-8314
E-mail: jkatz@joneswalker.com

2. AGENDA
• Basics of S Corporation Eligibility
• Consequences of Election
Termination
• Protecting the Election –
Shareholder Focus
– Organizational Diligence (Corporate
and S/H)
– Shareholder Eligibility and Protections
• Fixing a Failed Election

3. THE BASICS
• S Corporation Eligibility
Requirements:
– 100 or Less Permissible Shareholders
– One Class of Stock
– No DISC, Insurance Co or Financial
Institution
– Timely Election

4. THE BASICS
• Pop Quiz – Each family member in the
following family tree owns stock in the S corp.
How many S shareholders are there for
purposes of 100 s/h rule?

5. INTRODUCTION
• Three certainties in life:
– Death, Taxes, and…

6. INTRODUCTION
And …
S- Election Failures!!!
– Failure to make an effective
initial election, or
– Inadvertent termination of
S-election

7. CONSEQUENCES
• What happens when you’ve
discovered a bust in your S-
election?
–It looks a bit like this…

8. CONSEQUENCES

9. CONSEQUENCES
Guess when it is discovered?
When it matters!

10. CONSEQUENCES
• Corporation is a “C Corporation”
– Double Taxation
• Corporate Taxation on Net Profits
• Shareholder Taxation on Dividends
– Effective as of Date of Terminating
Event
• Short Period S and C Returns
• Taxable Period Until Discovery… A MESS!
• Statute of Limitations Concerns
– Prohibited from S Re-election for Five Years
• Even for inadvertent termination
– Qsubs Become C Corps

11. CONSEQUENCES
• S-Election Failures will:
– COST the Company & Shareholders
$$$
• Professional Fees
• Taxes on both the Corporate Level &
the Shareholder Level
– ANNOY Management and Shareholders
– DISTRACT from other Endeavors

12. CONSEQUENCES
In short, it is a MESS!

13. CONSEQUENCES
• Fixing the problem is like throwing
money away!

14. PROTECTING THE ELECTION
• Key Defensive Strategies
– Shareholders Agreement
– Initial and Ongoing Diligence

15. SHAREHOLDERS AGREEMENT
• Shareholders Agreement is a MUST!
• Key Provisions:
– Prohibit Transfers to Ineligible
Shareholders
• Subject to Declaration as Null and Void Ab
Initio
• Subject to Buy/Sell Provisions
– Fixed Price Buy Out
• Require Pre-Approval of All Proposed
Transfers
– Including proposed documentation of proposed
transferees
• Include Legend on Stock Certificates

16. SHAREHOLDERS AGREEMENT
• Key Provisions (cont’d):
– Obligate Shareholders to:
• Cooperate with Inadvertent Termination Waiver
from IRS
• Report Income Consistent with S Corporation Rules
• Consent to Prorate Income and Close Books
(Inadvertent Termination)
– Support with Power of Attorney from
each S/H
– Require Specific Performance
– Impose Express Liability for Failure to
Comply

17. DUE DILIGENCE
• Review Shareholder Documents –
– Trust Instrument:
• Include Provision Requiring Trustee to:
– Comply with Stockholders Agreement
– Maintain Trust as eligible S Corp. Shareholder
– Prevent any S stock transfer to an Ineligible
Shareholder
– Make any elections necessary OR advisable to keep
eligibility
• Include Corp. as Third Party Beneficiary
• Prohibit Trust Instrument Amendments w/o Consent
• Affidavit & Undertaking
– Disregarded LLC
• Provisions & Requirements Similar to Above
• Is it Disregarded?

18. DUE DILIGENCE:
Shareholder Eligibility
• Eligible
Shareholders
– Certain Trusts
– Estates
– U.S. Citizen or
Resident
Individuals
– Certain
Charities
• Ineligible
Shareholders
– Corporations
– Partnerships
– Nonresident Alien
Individuals
– Certain Trusts
• IRAs
• Charitable
Remainder Trusts

19. DUE DILIGENCE - Individuals
• Individuals
– U.S. Citizens or Residents
• Not these guys (unless residing in U.S):

20. DUE DILIGENCE - Individuals
• Individuals
– Includes:
• Minors
– S Consent – Legal Representative
– S/H Agreement – Legal Representative w/ Court
Approval
• Beneficiaries of Custodial Accounts
(UTMA/UGMA)
– S Consent – Legal Representative
– S/H Agreement – Custodian w/out Court
Approval

21. DUE DILIGENCE - Individuals
• Individuals
– Includes (Cont.):
• Split Interests
– Usufructuary / Naked Owner
» S Consent – Usufructuary
» S/H Agreement - Both
– Spouses in Community
» S Consent – Both!
» S/H Agreement – Name of Registration

22. DUE DILIGENCE - Individuals
• Individuals
– Includes (Cont.):
• Incompetent
Individuals
– S Consent – Curator / Legal Representative
– S/H Agreement – Curator / Legal Representative
» Court approval likely for both
• Disregarded LLCs
– S Consent – Tax Owner
– S/H Agreement – Authorized LLC Representative

23. CONSENT SUMMARY
SHAREHOLDER S ELECTION STOCKHOLDERS AGREEMENT
Who Signs? Court Approval? Who Signs? Court Approval?
Grantor Trust Grantor Not Typically Trustee No
QSST Income Beneficiary Not Typically Trustee No
ESBT Trustee No Trustee No
Minor Legal
Representative
Recommended Legal Representative Typically
UTMA/UGMA Legal
Representative
Recommended Custodian No
Usufructuary/ Naked
Owner
Usufructuary/ Life
Tenant
Not Typically Usufructuary & Naked
Owners
Not Typically
Spouses in Community Both spouses Not Typically Titled Spouse Not Typically
Estate (Succession) Executor Maybe Executor Maybe
Incompetent
Individuals
Curator Typically Curator Typically
Disregarded LLCs Tax Owner Not Typically Authorized Agent No
*Summary is general in nature and must be confirmed with app. state law

24. DUE DILIGENCE - Trusts
• Eligible Trust Shareholders
– Electing Small Business Trust (ESBT)
– Qualified S Corporation Trust (QSST)
– Grantor Trust
– Testamentary Trust
– Voting Trust

25. DUE DILIGENCE - ESBT
• ESBT Requirements (1361(e))
– U.S. Trust,
– Not Tax Exempt, CRAT or CRUT
– Beneficiaries are only U.S. Citizen or
Resident Individuals
– No Interest in Trust Acquired by
Purchase
– No QSST Election
– Timely & Correctly Filed ESBT Election

26. DUE DILIGENCE - ESBT
• ESBT Benefits:
– Trust Form Typically Unaffected by
ESBT Qualifications
• Include S Corp. Safe Harbor Language Noted
Above
– Very Limited Ongoing Oversight of ESBT
• Beneficiaries must continue to qualify
– Election Consent & S/H Agreement
Executed by Trustee
• Generally without needing court approval

27. DUE DILIGENCE - ESBT
• ESBT Pitfalls & Protections:
– Income Taxation
• S Corp’s Income Taxed at Highest Marginal Rate
• But: Only the S Portion (that is not grantored)
– Disqualified or Too Many Beneficiaries
• Potential Current Beneficiary (“PCB”) is
Nonresident Alien (or becomes NRA)
– One year transition period (1361(e)(2))
– Trust could exclude disqualified beneficiaries
• PCB > 100 Shareholders
– PCB is Deemed Shareholder for 100 S/H Rule

28. DUE DILIGENCE - ESBT
• ESBT Pitfalls & Protections:
– Election Failures
• Failure to File
– Company should handle election
– Mail election certified, return receipt requested
– Request stamped copy of election
– Secure “Acceptance” of election
– Follow Up
• Incorrectly Completed
– List All PCBs
– “Grantor” is a PCB (1361(c)(2)(B)(i)).

29. DUE DILIGENCE - QSST
• QSST Requirements (1361(d)(3))
– Only one income beneficiary permitted during the
current income beneficiary’s (“CIB”) lifetime
– No principal distributions to anyone other than CIB during
CIB's lifetime
– CIB's income interest must terminate at the earlier of CIB's
death or the trust’s termination
– CIB entitled to all trust assets if the trust terminates during
the CIB's life
– All of the trust's accounting income must either be
required to be distributed or actually distributed annually.
– DON’T FORGET: Timely & Correctly Filed QSST Election

30. DUE DILIGENCE - QSST
• QSST Benefits:
– Trust’s income taxed to the sole
income beneficiary at beneficiary’s
rate and not at the trust’s likely
higher rate
– Sole income beneficiary is sole S
shareholder, so easier to comply with
the 100 shareholder rule

31. DUE DILIGENCE - QSST
• QSST Pitfalls & Protections:
– Inflexible Trust Terms
• Mandatory v. Actual Distribution of Income
• Trust Term Limitations
• Loss of Creditor Protection
– Beneficiary signs S Election Consent
• Minor? Court Approval?
– Beneficiary’s Death
• Trust loses S/H eligibility after 2 years

32. DUE DILIGENCE - QSST
• QSST Pitfalls & Protections:
– Election Failures
• Failure to File
– Company should handle election
– Mail election certified, return receipt requested
– Request stamped copy
– Secure “Acceptance” of Election
– Follow Up
• Incorrectly Completed
– Court approval not secured for minor beneficiary

33. DUE DILIGENCE – Grantor Trusts
• Grantor Trust Requirements
– U.S. Trust
– Wholly Grantored to Eligible S Corp.
S/H under Section 671
– Examples:
• Revocable Trust – Settlor is grantor
• IDGT – Settlor is grantor
• GRAT or GRIT – Settlor is grantor
• Crummey Trust – Beneficiary is grantor

34. DUE DILIGENCE – Grantor Trusts
• Grantor Trust Benefits:
– No Election Required
– Trust’s income taxed to Grantor at
Grantor’s rates
– Flexible trust drafting
– Grantor treated as S/H for 100 S/H Test
• No Special Steps Required if Wholly
Grantored

35. DUE DILIGENCE – Grantor Trusts
• Grantor Trust Pitfalls:
– Not Grantor of ALL Income & ALL
Principal
– Termination of Grantor Status
• Grantor’s Death
– Trust qualifies for 2-Year period after death (1361
(c)(2)(A)(ii))
– Revocable Trust with 645 Election – Trust treated as
Estate
– Trust must make ESBT or QSST to continue to qualify
• Any Other Event
– Two Months and 16 Days!

36. DUE DILIGENCE – Grantor Trusts
– Termination of Grantor Status
(cont’d)
• Examples of “Other” Terminating Events:
– Release of IDGT Power by Grantor, Trustee or Trust
Protector
» Revocation Power, Power to Lend, Power to
Substitute
– Non-Grantor Donation
» Is it Still Wholly Grantored?
– Gift in Excess of Withdrawal Right – Crummey Trust
» Split Gifts – Gift Tax Return Filed?
» Valuation Risk – Adequate Disclosure?
» Improperly Filed Inc. Tax Returns

37. DUE DILIGENCE – Grantor Trusts
• Grantor Trust Protections:
– “Back-up” ESBT Election
• “Protective” not permitted, but “Real” are
• No Income Tax Effect – 1.641(c)-1(c)
– Grantor Trust income tax rules trump ESBT income tax
rules if Grantor Status in effect
– After termination - ESBT taxed at highest marginal rate
» Reform and convert to QSST (36 Months)
• ESBT Election Tips
– Grantor is PCB
– Trust may use Grantor’s SSN

38. DUE DILIGENCE – Grantor Trusts
• Grantor Trust Protections:
– “Protective” QSST Election
• Only available if Beneficiary is treated as
Grantor of Trust (i.e., Crummey Trust)
– 1.1361-1(j)(6)(iv)
• Protects against failure to be wholly grantored
to CIB

39. DUE DILIGENCE - Trusts
• Testamentary Trust:
– Trust must receive stock by Will
• Includes transfer from 645 Electing Rev.
Trust
– Trust qualifies for two years from
transfer date
– Estate is deemed owner of stock
– Income Taxation – Traditional tax
regime

40. DUE DILIGENCE – Voting Trusts
• Voting Trust:
– Each Beneficial Owner is Grantor of
portion
– Trust created by written instrument that:
• Delegates to trustee(s) the right to vote
• Requires all distributions be paid to, or on
behalf of, the beneficial owners
• Requires title and possession of stock to be
delivered to beneficial owners upon
termination
• Terminates under its terms or by state law on
or before a specific date or event.

41. DUE DILIGENCE - Estates
• Estates
– Qualified S/H during administrative period
so long as reasonable
• Once period expires, estate may be treated as
testamentary trust (adds an additional 2 years)
– Old Virginia Brick Co. Inc. v. Comm., 44 T.C. 724 (1966)
• Estate administrative period may be prolonged
by installment payments of estate taxes
– Rev. Rul. 76-23, 1976-1 CB 264.
– Executor signs consents and s/h
agreement, but court approval may be
necessary

42. TERMINATION RELIEF
• Community Property
– Rev. Proc. 2004-35
• Late Election Relief
– Rev. Proc. 2013-30
• Inadvertent Termination Relief
– Section 1362(f)

43. TERMINATION RELIEF
• Community Property S Election Relief
– Rev. Proc. 2004-35
– If the S Stock is community property, but
registered in one spouse’s name, both
spouses must sign S Corp. Election Consent
(IRS Form 2553)
– If one spouses fails, relief allowed if this is
sole defect of S Election and all S
Corporation items previously reported by
both spouses
– Obtained by statement filed with IRS

44. TERMINATION RELIEF
• Late Election Relief
– Certain Entities Eligible for Relief for Filing
Elections in Untimely Manner
– Elections Covered:
• S Election
• ESBT Election
• QSST Election
• QSub Election
• Corporate classification election made in
connection w/ S Election

45. TERMINATION RELIEF
• Late Election Relief
– Relief permitted if:
• Entity fails to qualify solely because it failed to
timely file the election
• Entity has reasonable cause for the failure to file
• All S Corporation and Shareholder returns
reported income consistently as if the election
was effective
• Relief sought within 3 Years and 75 Days after
the intended effective date of the election

46. TERMINATION RELIEF
• Inadvertent Termination Relief (1362(f))
– Corporation’s S Election Treated as
Continuing if:
• Corp. validly elected status and election
terminated
• IRS determines termination inadvertent
• Corporation takes steps to cure within
reasonable period after discovering terminating
event
• The Corp. and S/Hs agree to any IRS required
adjustments for the termination period
– Request MUST be via a PLR (Treas. Reg.
1.1362-4(c))

47. SUMMARY
• Key Takeaways:
– Initial Election - Diligence
– Stockholders Agreement
• Make sure right people sign with proper
authorization
– Continued Diligence
• Review Transfers
• Require Backup Elections
– Stay away from
• Minors
• Disregarded LLCs
• Grantor Trusts (without backup election)