The S corporation continues to be a popular entity choice, combining the liability protection of a corporation with many of the tax benefits of a partnership. But these benefits come at a price: S corporations must comply with strict requirements that limit the number and type of shareholders, prohibit complex capital structures, and impose other restrictions.
Like a traditional corporation, an S corporation shields its shareholders from personal liability for the corporation’s debts. At the same time, it provides many (though not all) of the tax benefits associated with partnerships.
The most important tax benefit is that an S corporation, like a partnership, is a “pass-through” entity, which means that all of its profits and losses are passed through to the owners, who report their allocable shares on their personal income tax returns. This allows S corporations to avoid the double taxation that plagues traditional C corporations, whose income is taxed at the corporate level and again when distributed to shareholders.
S corporations, unlike partnerships, lack the flexibility to allocate profits and losses among their shareholders without regard to their relative capital contributions. But S corporations have one important advantage over partnerships: Shareholders need not pay self-employment taxes on their shares of the profits, provided they receive “reasonable” compensation.
To qualify as an S corporation, Form 2553 — Election by a Small Business Corporation — must be filed with the IRS. In addition, the corporation must:
Allowable shareholders include individuals, estates and certain trusts. Partnerships, corporations and nonresident aliens are ineligible. A trust is an allowable shareholder if it’s domestic and qualifies as one of the following:
Be aware that grantor and testamentary trusts are eligible shareholders for only two years after the grantor dies or the trust receives the stock.
Preserving S corporation status requires due diligence. Among other things, you should:
Also, avoid actions that may be deemed to create a second class of stock, such as making disproportionate distributions.
If your business is organized as an S corporation, it’s critical to monitor your shareholders and activities continually to avoid inadvertent termination of your company’s S corporation status. At worst, termination means the loss of substantial tax benefits. At best, it means going through an expensive, time-consuming process to seek relief from the IRS and, if successful, have your S status restored retroactively.
If you have any questions about the information above, lease contact your E. Cohen advisor.
