I’ve been a big fan of the FX series “Justified” the last few years.
Based on an Elmore Leonard short story, “Fire in the Hole,” the series follows the life of a fictional US Marshal named Raylin Givens as he works the coal mine region of eastern Kentucky, transferring prisoners, protecting federal witnesses, and seizing the property of criminals.
None of this, on the face of it, seems to have anything to do with a small business S corporation. Or at least that’s what I thought, until the US Marshals Service—the real US Marshals Service—contacted me with an S corporation question a few months ago.
But let me explain.
The Ominous Email from the US Marshals Service
In October of 2013, I received the following email from an individual working in the Asset Forfeiture Division of the United States Marshals Service:
Mr. Nelson-
I came across your website while I was trying to conduct some research for shareholder restrictions of a S Corporation. If you would kindly indulge me, I need your expertise on an issue that came up recently.
An individual shareholder owns shares of stock in a S-Corp. The individual was convicted of a crime and his stock was forfeited to the U.S. Government. The U. S. Government has seized the stock and will dispose of the stock by selling it to another individual. With the restrictions of who can be a S-Corp shareholder, does the forfeiture, seizure and subsequent sale of stock jeopardize the company’s S-Corp status?
Any information you could provide, would be greatly appreciated.
Regards,
Wow. Scary, right?
Note: The website the Marshals Service contractor references in this message above is my www.scorporationsexplained.com website.
The Problem in Partnering With the US Marshals Service
I answered this question (just as freebie) simply because, as mentioned, I’m a big fan of a TV show about US Marshals. How could I not help a real-life counterpart of the fictional character Raylin Givens.
But it’s struck me in the weeks since answering this question, that the answer becomes relevant to many small businesses. And here’s why: S corporation shareholders need to be really careful about monitoring the eligibility of their shareholders. Only eligible shareholders can own shares. And if an ineligible shareholder owns shares, boom, the S corporation blows up.
Which brings us back to the subject of the email from the US Marshals Service. The U.S. Government (and in fact any government or government agency) can’t legally own stock in an S corporation.
Only US citizens and permanent residents (and some special situation shareholders like your estate when you die) count as eligible S corporation shareholders.
Through the seizure and forfeiture referenced in the email I received, the US Government became a shareholder in an S corporation and then triggered an immediate termination of the S corporation’s tax reporting status. Ouch.
People might say, hey, that’s tough…a criminal gets what he or she deserves.
But the rub here is that the termination of the Subchapter S status doesn’t actually hurt the person who’s already forfeited the assets. The termination hits the remaining shareholders and the corporation.
The continuing shareholders now own a regular C corporation. So from the point of termination and forward, these existing shareholders now pay both corporation taxes and individual income taxes on the business profit.
What’s more, the termination event itself creates quite a bit of extra work and fiddling, including a couple of short-year tax returns (one for the part of the year that the entity is an S corporation and one for the part of the year that the entity is a regular C corporation.)
Protecting Against Asset Seizure and Forfeiture Disasters
Enough storytelling though. The blog covers practical how-to advice for small business owners. So let me try to do that here.
I propose my little brush with the US Marshals Service suggests three risk minimization tactics all S corporations and their shareholders should consider…
The first and most obvious tactic: Be careful about who you co-own an S corporation with. Because in that worst case scenario, you could have your S corporation’s status terminated because of something terribly dumb some shareholder does.
A second tactic to consider: If you’ve collaborated with several people to go together and share ownership of a business, consult with your attorney about having a shareholders agreement written and placed into service. Via that agreement, shareholders can promise they won’t do anything that triggers a termination of Subchapter S status. In such an agreement, the owners can indemnify the S corporation and other shareholders against damages if they do cause a termination.
A third tactic may also be available in some states: Pretty much anywhere, a creditor, a government entity, and a law enforcement agency can seize stock in a corporation. However, in some states, these outside parties can’t seize an interest in a limited liability company.
If you’re setting up an S corporation, therefore, ask your legal adviser about using a limited liability company for the S corporation platform rather than using a traditional corporation for the S corporation platform.
Note: An S corporation, and hopefully you already know this, isn’t actually a corporation. It’s an entity that’s made a Subchapter S election. Traditionally only corporations made the election—which is why people use the label “S corporation.” But other entities, including most popularly, limited liability companies, can also make a Subchapter S election.
And a final important clarification: The LLC doesn’t make your S corporation immune to government asset seizures and forfeitures and creditor claims directed against the entity’s owners. These outsiders may be able to get a charging order from a court that says any profit distributions from the business that would have gone to the targeted co-owner should instead go to the outsider. But a charging order only hurts the shareholder in trouble, not the S corporation and all the rest of the S corporation owners.