To make an S election, all shareholders must consent. § 1362(a)(2). But who counts as a shareholder? The Tax Court held in Kean v. Commissioner, 469 F.2d 1183 (9th Cir. 1972), that beneficial owners, not just record holders, must consent.
In Kean, William MacPherson held 125 shares of S corporation stock in his name. But he held half of those shares as a beneficial owner for his brother, Murdock. The IRS argued Murdock should have consented to the S election. The court agreed, applying Reg. § 1.1371‑1(d)(1), which says the persons who would have to include dividends in income are the shareholders.
The court upheld the regulation, noting that Congress intended the real owners (those who would bear the tax consequences) to have the right to consent. The case also shows that the IRS has discretion to extend the time to file consents under Reg. § 1.1372‑3(c). The court found the District Director abused his discretion in denying an extension here.
What if a minority shareholder wants to terminate the S election by transferring shares to an ineligible shareholder? In A.W. Chesterton Co. v. Chesterton, 128 F.3d 1 (1st Cir. 1997), a minority shareholder threatened to transfer his shares to two shell corporations, which would terminate the S election. The court enjoined the transfer under Massachusetts fiduciary duty law. So state law may provide a remedy, but it’s not automatic.
The lesson: if you’re forming an S corporation, make sure all beneficial owners consent. And consider a shareholders’ agreement restricting transfers that would jeopardize S status.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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