One of the defining characteristics of the S corporation is the limit on the total number of allowable shareholders. When Subchapter S of the Internal Revenue Code first came into existence in 1958, an S corporation was limited to 10 shareholders. This limit was first increased to 25 in 1976 and has grown progressively larger over the years. It was most recently raised to 100 as a result of the American Jobs Creation Act of 2004. This most recent increase in the shareholder limit, however, was accompanied by another provision that arguably had a greater impact on the number of individuals who could own S corporation stock. The family shareholder rules allowed for all members of a family to be treated as a single S corporation shareholder for purposes of the shareholder limit.
The family shareholder rules are found in Internal Revenue Code Section 1361(c) and Treasury Regulation 1.1361-1(e)(3) and provide that stock owned by members of a family is treated as owned by one shareholder, but only for purposes of the maximum shareholder limit. Members of a family are defined to include a common ancestor and all lineal descendants, including spouses and former spouses of such descendants. In addition, all legally adopted children, children who have been placed with an individual for legal adoption, and any eligible foster children will be treated as blood-related to such individuals. Finally, estates of deceased individuals, grantor trusts, and beneficiaries of other eligible trusts (such as QSSTs, ESBTs and voting trusts), provided those beneficiaries are members of the family, will qualify for treatment as a single shareholder.
As originally enacted, treatment of a family as a single shareholder required an election by at least one of the members of the family. This election regime, however, was discarded in 2005 by the Gulf Opportunity Zone Act and all family groups holding S corporation stock will automatically qualify for treatment as a single shareholder.
The only additional requirement is that on the applicable date, the common ancestor cannot be more than six generations removed from the youngest generation of shareholders. This “applicable date” is the latest of: (1) the date the Subchapter S election was made; (2) the earliest date that a member of the family held stock in the S corporation; or (3) October 22, 2004 (the effective date of the American Jobs Creation Act). Note that this test only applies for purposes of finding a common ancestor and effectively limits how far back in time one can go to identify a common ancestor. Once this common ancestor has been identified under the “six-generation test,” lineal descendants (and their spouses) more than six generations removed from the common ancestor who later acquire stock in the corporation will also be treated as members of the family.
The result of the family shareholder rules is the potential for a greatly expended shareholder group (well in excess of the statutory 100 shareholder limit). The rules are especially impactful for wealth transfer and estate planning purposes and allow older generations to transfer stock in S corporations to younger generations at an earlier stage without worrying about bumping up against the shareholder limit.
The expansive definition of “members of a family,” however, also creates some complexity for the S corporation in terms of tracking the number of shareholders. It becomes increasingly important to keep detailed records of stock ownership and transfers, especially for S corporations that are approaching the 100 shareholder limit or that have multiple large family groups as shareholders. We highly recommend that S corporations review their stock ownership and transfer records to ensure that family groups are being tracked appropriately. For example, the creation of a family tree for each family group that holds stock in an S corporation can assist with tracking transfers among family members and can avoid an inadvertent increase in shareholders beyond the limit.