IRS Permits Momentary Ownership of S Corporation Stock by an IRA
April 2001
A recent IRS private letter ruling obtained by McDermott Will & Emery should simplify the distribution procedures for employee stock ownership plans (ESOPs) sponsored by subchapter S corporations.
Under a law that first became effective in 1998, ESOPs are now permitted to be stockholders of S corporations. S corporations that are 100 percent (or nearly 100 percent) owned by an ESOP are becoming more widespread, because neither the corporation nor its tax-exempt ESOP shareholder are required to pay any federal income tax.
However, an administrative problem faced by S corporation ESOPs is the general ESOP requirement that benefits for participants must be distributable in the form of company stock. If a participant who becomes entitled to a distribution from the ESOP (e.g., due to retirement, death, disability or other termination of employment) elects to take his distribution in the form of company stock and also elects to have his or her distribution transferred directly to an IRA under Code section 401(a)(31), then the IRA would become the owner of the S corporation’s stock. That could be a problem because IRAs are not permitted to be S corporation stockholders, and ownership of even a single share of an S corporation’s stock by an impermissible holder results in automatic involuntary termination of S corporation status.
Code section 409(h)(2) provides some protection against this occurrence by permitting the stock distributed by an S corporation ESOP to be subject to a requirement that it immediately be resold to the ESOP company. However, even an immediate sale by the IRA would still result in the IRA’s ownership of the distributed S corporation stock for a theoretical instant in time, which some have feared would result in an involuntary termination of S corporation status.
The ruling request that McDermott Will & Emery submitted on behalf of its client sought prospective relief from this result for future ESOP distributions of S corporation stock, based on the following three grounds:
1. IRS has granted dozens of other requests to disregard momentary ownership of S corporation stock when the momentary owner is a corporation or a partnership and, therefore, should reach the same result when the momentary owner is an IRA.
2. Treas. Reg. § 1.1377-1(a)(2)(ii) provides that a shareholder who disposes of stock in an S corporation is treated as the shareholder for the day of the disposition. Logically, this would appear to mean that the ESOP is treated as the shareholder for the day on which the stock is transferred to the IRA. If the IRA sells the stock back to the company or the ESOP on the same day, then the company or the ESOP is treated as the owner of the stock on the next day. Since there is no day on which the IRA is treated as the owner of the stock under this regulation, it should not be treated as ever having owned the stock for purposes of involuntarily terminating the corporation’s S status.
3. The administrative burden of the alternatives available to the company if it could not continue its practice of making stock distributions, subject to a right of immediate repurchase, was quite substantial.
After taking a tentative position adverse to granting the request, representatives of the IRS met with representatives of the company and received some additional information. Shortly thereafter, the IRS granted a favorable ruling, stating that "the Company’s status as an S corporation will not terminate if the ESOP makes distributions of Company stock, and one or more participants elects to make a direct rollover to an IRA, provided that the stock is immediately repurchased by Company." The company’s procedure is to have the participant, or his IRA custodian, sign an irrevocable stock transfer form prior to receiving the distribution. Although a stock certificate is prepared, it never leaves the company’s premises and is retired the same day. By monitoring the timing of stock distributions, the company ensures that it will never have more than 75 shareholders (including momentary shareholders) on any given day.
The ruling does not indicate its rationale but merely recites the facts and states the conclusion. Based on our discussion with the IRS representatives, we surmised that they were not moved by the analysis under Treas. Reg. § 1.1377-1(a)(2)(ii), which could be regarded as "proving too much" because it would justify ownership for less than a day by any otherwise impermissible S corporation holder. What seems to have made more of a difference was the argument that the administrative burden resulting from forcing participants to do indirect rollovers (in which the stock is distributed to the participant, who has to sell it back to the company and then reinvest the sale proceeds in an IRA within 60 days) was substantial. Because this burden was so substantial, and because the IRS representatives agreed that no tax policy purpose would be served by terminating the company’s S corporation status under these circumstances, we argued that the IRS should expand on its line of rulings to the effect that corporations and partnerships can be momentary owners of S corporation stock, which often arise in cases where a corporation is to be created and spun off from its parent (which, as a corporation or partnership itself, is an impermissible owner for the instant in time between the creation of the corporation to be spun off and the actual spinoff).
The ruling does differ qualitatively from the previous rulings that deal with corporation and partnership momentary ownership, however, because each of these prior rulings involved only a single discrete event, while this ruling gives a carte blanche for an unlimited number of future direct rollovers of stock from the ESOP to an IRA.
Note that this is a private letter ruling, not a published revenue ruling; therefore, no taxpayer other than the company to which it was addressed is entitled to rely on it. However, we believe it is likely that any other ESOP S corporation that applied for a similar ruling would receive one, and that the position of the IRS National Office is that S corporations should not suffer loss of their S corporation status due to momentary ownership of their stock by an IRA under these circumstances.
