February 05, 2014 Articles

Minority Shareholder Threats to Subchapter S Elections

Reviewing recent judicial responses

by Paula M. Bagger

Family businesses organized as closely held corporations often qualify for "S corporation" status under federal tax law. Corporations that make a subchapter S election, see 26 U.S.C. §§1361–1379, are taxed like partnerships:  There is no income tax at the entity level, and all income and loss "passes through" to the shareholders.  S corporation status is generally viewed as desirable because shareholders avoid so-called "double taxation," which occurs when corporate earnings are taxed first as income to the corporation and then as dividends to the shareholders.  Not any small corporation may make a subchapter S election, however.  In order to qualify as an S corporation—and retain this status—a corporation may have no more than 100 shareholders, all of whom must be natural persons or trusts and none of whom can be nonresident aliens.  Id. § 1362(d). 

Absent restrictions in the Articles of Incorporation or a shareholders' agreement, any shareholder in an S corporation is in a position to cause an involuntary termination of the corporation's subchapter S status. A shareholder need only transfer his or her stock to a corporation, nonresident alien, or other non-qualifying person or entity. Amid the multitude of ways in which the majority shareholders of a closely held corporation may oppress the minority, the need for every shareholder to refrain from disqualifying transfers creates a rare instance in which a minority shareholder is in a position to hold the majority hostage, as he or she has the means at his or her disposal to cause significant damage to the corporation and its shareholders. 

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