Be careful with that S corporation selection

jason harrel
Jason Harrel

An S corporation is a corporation that has elected under the Internal Revenue Code to be taxed as a small business corporation pursuant to Section 1362.  This allows them to avoid the double taxation it would face if it were taxed as a C corporation.

Another big benefit is the possible avoidance of Social Security and Medicare taxes on distributions of profits. However, not all small businesses can qualify as an S corporation.

Here are the basic requirements to make the S election:

  • have 100 shareholders or fewer
  • have only eligible shareholders (individual, certain trusts and estates)
  • have no nonresident aliens as shareholders
  • have only one class of stock
  • have no more than 25 percent of gross receipts from passive investment income for more than three consecutive years if it’s a former C corporation.

The issues that typically jeopardize the S election are the eligibility of shareholders and the one class of stock requirement.

S corporation shareholders generally have to be individuals.  A partnership entity is not an eligible shareholder of an S corporation. Trusts and estates can be eligible shareholders of an S corporation, but additional rules have to be followed. For trusts, a grantor trust is a permissible shareholder if all the income of the trust is taxed to the grantor/settlor of the trust.

Other types of irrevocable trusts in which the income is taxed to someone other than the grantor/settlor of the trust can be a permissible shareholder,  but additional elections have to be made. For example, if an irrevocable trust is set up by someone and the income from the trust is to be paid to another single individual, then an additional Qualified Subchapter S Trust (QSST) election must be made.

Alternatively, if an irrevocable trust is set up by someone and the income from the trust is to be taxed to more than one individual, then an Electing Small Business Trust (ESBT) election has to be made.

Failure to file either of these additional elections can cause the S election to be terminated. That, in turn, would cause the corporation to be taxed as a C corporation subject to double taxation.

Care should be taken when you have an S corporation with multiple shareholders.  Strong consideration should be made to having a Shareholder Agreement or Buy-Sell Agreement that restricts who the shares can be transferred to.

Such a Shareholder Agreement would provide that if someone makes a transfer to an impermissible shareholder which would cause the termination of the S election, that transfer would be deemed void or would trigger a buy-sell as of the date of the impermissible transfer.

Such agreements should also contain consents from the offending shareholder to the filing of amended tax returns to correct the previously filed incorrect tax returns and require payment of damages for the violation of the Shareholder Agreement. This can be a complicated agreement and care should be taken in drafting of it.

Although the Internal Revenue Code contains provisions for relief from inadvertent election terminations, one does not want to rely on the IRS’ forgiveness.  A backup Shareholder Agreement should be in place to address an impermissible transfer.

Another issue that typically comes up with S corporations is the one class of stock requirement. That requirement means that all shareholders have the same rights and privileges with respect to their stock. Most importantly, distributions of profit are made to all the shareholders according to their percentage interest in the company. Any other distribution to shareholders need to take place through payroll compensation. To avoid problems with this rule, such compensation agreements should be in writing.

However, the one class of stock requirement does not prevent an S corporation from having voting and non-voting shares of stock. So long as shareholders have the same rights and privileges with respect to income, distributions and liquidation proceeds, the presence of voting and non-voting shares will not violate the one class of stock requirement.

Overall, S corporations provide a good tax structure for business entities.  However, care must be made to maintain the election or drastic tax ramifications can result from a termination of the S election.


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