IRS ruling liberalizes S limits on number of shareholders.

The IRS has recently issued a favorable revenue ruling that should give corporations more flexibility in the structuring of corporate entities by allowing business groups with more than 35 shareholders to elect S status. In Rev. Rul. 77-220, the Service did not allow three separate corporations to make valid S elections. The three separate corporations had 10 shareholders each and were operating one business linked by a single partnership (at the time of the ruling, S corporations were limited to no more than 10 shareholders). The IRS ruled that, for purposes of the S election, the three corporations would be considered a single corporation, thereby making the S election invalid. Apparently, the only reason for the three separate corporations was to qualify to make S elections.

In Rev. Rul. 94-43, revoking Rev. Rul. 77-220, the Service stated that the proposed structure did not affect "administrative simplicity."

The purpose of the number of shareholders requirement is to restrict S corporation status to corporations with a limited number of shareholders so as to obtain administrative simplicity in the administration of the corporation's tax affairs. In this context, administrative simplicity is not affected by the corporation's participation in a partnership with other S corporation partners; nor should a shareholder of one S corporation be considered a shareholder of another S corporation because the S corporations are partners in a partnership.

The number of shareholders that an S corporation can have has increased from 10 in 1958, to 15 in 1976, to 25 in 1981 and finally to the present 35 in 1981 (Sec. 1361(b)(1)(A)). In 1982, the Senate Finance Committee Report stated that the 35-shareholder limit corresponded to the private-placement exception under Federal securities law. The intention appears to have been to place limitations on the use of an S corporation as a vehicle for raising capital through a public offering or a private placement.

Of course, the 35-shareholder limitation restricts not only businesses that could potentially raise capital through public offerings, but also other types of businesses that are quite suitable for S status but simply have too many shareholders. Probably the most common types of businesses in this second category are professional corporations, such as large law, engineering or architectural firms presently operating as partnerships but wanting to incorporate for nontax reasons. Such professional corporations can incorporate and operate as regular C corporations, but C corporations do not provide the flexibility as to cash distributions that S corporations have; in addition, they can create double taxation both in operations and on liquidation. The IRS has previously allowed (in Letter Rulings 8950066 and 8823027) the formation of single-shareholder S corporations as substitutes for individual partners of a partnership for purposes of limiting potential liability for legal malpractice. The Service considered the formation of the S corporations in these circumstances to have valid business purposes. There have also been a number of other letter rulings in which the IRS has allowed S corporations to use partnerships to circumvent the number-of-shareholders requirement, but only when there appeared to be a business puropose for the arrangement (Letter Rulings 9025022, 9026025-9026029, 9026031, 9026032, 9026034, 9026035 and 9409027).

Rev. Rul. 94-43 will give tax advisers a new tool when structuring S corporations, since it has greater authority than a letter ruling and did not include any business purpose requirement. Therefore, businesses with more than 35 owners that want corporate protection and either cannot or do not want to operate as a limited liability company should reconsider an S election, based on the more creative structures that appear to be allowed by Rev. Rul. 94-43.