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12 • 2015

The Risk Of Having A Foreigner Be A Shareholder Of An S Corporation

S corporations offer several advantages, including pass-through taxation at the federal level. That is, an S corporation does not pay federal taxes at the corporate level; instead, business income is passed through to shareholders who report it on their personal income tax returns, thereby avoiding double taxation on corporate income.

The Internal Revenue Code defines an “S corporation” as a “small business corporation” for which all of its shareholders have consented to elect S corporation status for that taxable year.[1] A “small business corporation,” in turn, is a U.S. corporation that (1) has 100 shareholders or less; (2) has only individuals as shareholders (with the exception of estates and certain trusts); (3) has only one class of stock; and (4) does not have a “nonresident alien” as a shareholder.[2] Importantly, an election to be treated as an S corporation for a particular taxable year “shall be terminated whenever . . . such corporation ceases to be a small business corporation.”[3] Such a termination is effective immediately.[4] The loss of S corporation status during a taxable year can have disastrous tax consequences to the shareholders of the corporation.

In general, the requirements for being a “small business corporation” can be controlled by the corporation’s shareholders. For example, the corporation can ensure that it is not creating more than one class of stock or selling its stock to more than 100 shareholders or to partnerships or other corporations. But if an existing shareholder fails to maintain his status as a “resident alien” for unforeseen reasons, there is little the other shareholders can do to control that eventuality.

For purposes of the Internal Revenue Code, a person is a “nonresident alien” if he is neither a citizen nor a resident of the United States.[5] An alien is a U.S. resident if he (1) has been lawfully admitted for permanent residence (i.e., has a green card) at any time during the calendar year; or (2) meets the “substantial presence” test.[6]

A person generally satisfies the substantial presence test if he was physically present in the United States for at least 31 days during that calendar year and for at least 183 days during a three-year period that includes the calendar year.[7] Even if they are physically present in the United States, certain “exempt individuals” are not treated as being present in the United States.[8] Exempt individuals include certain persons temporarily present in the United States, including a teacher or trainee, a student, and a person related to a foreign government (such as a diplomat).[9] As such, a corporation wishing to maintain its status as an S corporation should be especially careful about selling its shares to a foreigner who would qualify as an exempt individual under the Internal Revenue Code.

To be clear, it is not illegal for a nonresident alien to purchase stock in an S corporation.[10] But if a nonresident alien buys stock in an S corporation, or if an alien shareholder does not have a green card and fails to meet the substantial presence test in a particular year, then the corporation will lose its tax status as an S corporation.[11] So, for example, if an alien shareholder is unable to travel to, and be physically present in, the United States for at least 31 days in the calendar year due to an unexpected illness, then the corporation can lose its S corporation status, and all of the shareholders will suffer the tax consequences. For that reason, an S corporation must be very cautious about having foreigners as shareholders (and the risk is obviously multiplied the more foreign shareholders an S corporation has).

[1]26 U.S.C. §§ 1361(a)(1), 1362(a); see also 26 C.F.R. § 1.1361-1(a)(1).

[2]See 26 U.S.C. ‘ 1361(b)(1); 26 C.F.R. ‘ 1.1361-1(b)(1).

[3]26 U.S.C. § 1362(d)(2)(A).

[4]See id. § 1362(d)(2)(B) (termination of S corporation status “shall be effective on and after the date” the corporation ceases to be a small business corporation).

[5]See id. § 7701(b)(1)(B).

[6]See id. § 7701(b)(1)(A); 26 C.F.R. ‘ 301.7701(b)‑1. A person can also elect to be treated as a resident alien during his first year of residency in the United States, 26 U.S.C. § 7701(b)(4)(B), but the election remains in effect only for the year in which it is made, id. § 7701(b)(4)(F).

[7]See 26 U.S.C. § 7701(b)(3); 26 C.F.R. ‘ 301.7701(b)-1(c); Zhengnan Shi v. Comm’r, 108 T.C.M. (CCH) 212 (T.C. 2014).

[8]See 26 U.S.C. § 7701(b)(3)(D); 26 C.F.R. § 301.7701(b)‑3(a)(1).

[9]See 26 U.S.C. § 7701(b)(5); 26 C.F.R. § 301.7701(b)‑3(b).

[10]See Rullan v. Goden, No. Civ. CCB-12-2412, 2015 WL 5673010, at *14 (D. Md. Sept. 23, 2015).

[11]See id.; Nallaballi v. Achanta, No. 298042, 2011 WL 2555717, at *3 (Mich. Ct. App. June 28, 2011) (unpublished opinion).