If you have chosen the S corporation form for your business, you should be aware of certain steps that you should take to avoid an inadvertent termination of S corporation status.

 Avoid transfers to ineligible shareholders. In general, the only types of shareholders which an S corporation may have are individuals who are U.S. citizens or residents, a decedent's estate, certain types of trusts, and certain exempt organizations. Therefore, it is important that you confirm that all the shareholders are eligible to be S corporation shareholders, i.e., that no shareholder is a nonresident alien; a partnership; or a corporation; that all trusts are properly structured to be eligible shareholders and that any elections required for a trust have been made.

 Even if a corporation's initial shareholders are all eligible shareholders, S corporation status will be terminated if any shares are transferred to a nonresident alien individual, a corporation, a partnership, or a trust (other than the specific types of trusts which are permitted to be S corporation shareholders).

 In order to prevent a shareholder from causing a termination of S corporation status by transferring his shares to an ineligible shareholder, a shareholders' agreement should prohibit transfer of any shares to a person other than a permitted S corporation shareholder, and require a similar undertaking on the part of any transferee, as a condition to any transfer. In addition, if permitted by local law, an appropriate restriction should be imposed in the corporation's charter or by-laws so that a purported transfer to an ineligible shareholder would be void.

  Avoid violating the shareholder limitation. An S corporation cannot have more than 100 shareholders. Even if this limit is not exceeded initially, S status will terminate if, as a result of new issuances or transfers of shares, the limit is exceeded at any time in the future.

 New issuances of stock require corporate action, and you should keep this rule in mind when considering future issuances of stock so that the 100 shareholder limitation will not be exceeded.

 Transfers by shareholders can be somewhat more problematic, since they can occur without any action on the part of the corporation. Therefore, if the transfer would cause the 100-shareholder limit to be exceeded, a shareholders' agreement should prohibit the transfer of any shares to a person who is not already a shareholder. A similar restriction should be imposed on the transferee. In addition, if permitted by local law, an appropriate restriction should be imposed in the corporation's charter or by-laws so that a purported transfer that caused the limit to be exceeded would be void.

 Don't issue more than one class of stock. An S corporation can only have one class of stock. Be sure to keep this requirement in mind when considering future changes to the capital structure of the corporation. The IRS allows S corporations to use various equity incentive compensation arrangements without violating the one class of stock restriction.

 Avoid excess passive investment income. If an S corporation has accumulated earnings and profits (because it was once a C corporation or is a transferee of a C corporation), its S election will terminate if, for a period of three consecutive tax years, its “passive investment income” exceeds 25% of its gross receipts.

 The first step in avoiding an inadvertent termination under this rule is to keep track of the corporation's passive investment income to determine whether the 25% limitation may be exceeded. Although excess passive income is subject to a special tax, S corporation status will terminate only if the limit is exceeded for three consecutive years. Thus, if you are willing to pay the tax, you can monitor the results of two years' operations while you plan to avoid a termination.

 If a corporation is in danger of exceeding the 25% passive income limitation for three years, there are two basic approaches to avoid termination of S corporation status. Since termination will only occur if the corporation has accumulated earnings and profits from C corporation years, termination can be avoided by stripping out those earnings and profits by way of a dividend. Ordinarily, distributions by an S corporation reduce pre-S corporation earnings and profits only after the accumulated income from all S corporation years has been distributed. However, it is possible to elect to treat distributions as coming from pre-S corporation earnings and profits first. Moreover, if it desired to strip out earnings and profits without actually depleting the corporation's cash or other liquid assets, a “deemed” dividend election can be made. Be aware, however, that a distribution out of pre-S corporation earnings and profits (whether actual or under the deemed dividend election) is generally taxable to shareholders as a dividend (unlike a distribution from accumulated S corporation income which is generally a return of capital).

 A second approach to avoiding termination under the passive income rules is to tailor the corporation's operations so that the 25% passive income limit is not exceeded. Since termination will occur only after the limit is exceeded for three consecutive years, if you are willing to incur the tax on excess passive income, there should be sufficient time to take action to avoid a termination.

 This can be done by reducing the amount of passive investment income, or by increasing the amount of other income. Since the test is applied to gross receipts, acquiring a business which produces receipts which are not passive investment income, even if it does not produce much in the way of net income, is one possible solution. It may also be possible to restructure certain operations so that passive income (e.g., certain rental income) becomes active income. (Unfortunately, an investment in municipal bonds producing tax-exempt interest is not a solution under these rules.)