What is an S Corporation?
An S corporation is a corporation that is not taxed separately from its owners. The term S corporation is used to distinguish S corporations from C corporations, which are subject to double taxation.
S corporations provide the liability protection of a corporation with the flow-through taxation of a partnership. In that respect, they are similar to limited liability companies and some forms of limited partnerships. But because S corporations are subject to burdensome requirements, limited liability companies are often a better choice for small businesses.
The formation of a corporation under state law will automatically classify it as a C corporation for Federal tax purposes1 To convert to an S corporation, the shareholders must elect to be taxed under Subchapter S of the Internal Revenue Code. The election is made by filing a Form 2553, Election by a Small Business Corporation.
Double Taxation: Separate vs. Pass-Through Treatment
S corporations do not pay income taxes. Instead, an S corporation’s income, losses, deductions and credit are passed through to the shareholders for Federal tax purposes and taxed directly to them.2 This avoids the double taxation that applies to C corporations, but not without exception. Specifically, any gain that a S corporation recognizes within 10 years after electing to convert from a C corporation to an S corporation are taxed as though the asset was still owned by a C corporation.3 This “built-in gains tax” is imposed at the highest corporate tax rate.
Double taxation is also a concern for former C corporations with passive investment income.4 A corporate-level tax is imposed if the S corporation’s passive investment income exceeds 25 percent of its gross receipts and the S corporation has accumulated earnings and profits.5 The tax is imposed at the highest corporate tax rate. And if the S corporation has both accumulated earnings and profits and excess passive investment income for three consecutive tax years, S corporation status will be lost on the first day of the fourth tax year.6
Restrictions on Ownership
Unlike C corporations, ownership of S corporations is restricted. An S corporation cannot have more than 100 shareholders.7 For purposes of this 100-shareholder limit, husbands and wives (and their estates) and certain family members are treated as a single shareholder, and stock owned by both a grantor trust and the grantor of the trust is treated as being owned by one shareholder.
The Internal Revenue Code also restricts the types of shareholders that can qualify as “eligible shareholders” of S corporations. Eligible shareholders include individuals, decedents’ estates, bankruptcy estates, certain types of trusts, or charitable organizations.8No shareholder may be a nonresident alien or individual married to a nonresident alien who has a current ownership interest in his or her stock under local law (unless the nonresident alien spouse elects to be taxed as a U.S. resident under Code § 6013(g)).9
Restrictions on Capital Structure
Unlike C corporations, S corporations can only have one class of stock. The corporation is treated as having only one class of stock if all shares of stock have identical right to distributions and liquidation proceeds and the corporation hasn’t issued any instrument or obligation or entered into any arrangement that may be treated as a second class of stock.10 The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions). A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a principal purpose of the agreement is to circumvent the one class of stock requirement.
Differences in voting rights are disregarded for purposes of determining whether the corporation has more than one class of stock.11 If all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.12
Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless: (a) a principal purpose of the agreement is to circumvent the one class of stock requirement; and (b) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.13 Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. Similarly, bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.
Adjustments to Basis at Death
Stock owned by a deceased subchapter S corporation shareholder is entitled to a basis step up at the deceased shareholder’s death.14 But the S corporation’s basis in the underlying assets is not affected by the shareholder’s death. This means that the sale of appreciated assets by the corporation results in taxable gain to the corporation, and that gain is passed through to the deceased shareholder’s estate or heirs.
Profit distributions to a shareholder from an S corporation are not considered “wages” for purposes of Code §§ 3121(a) and 3306(b) and are thus not subject to employment taxes. But payments received by the shareholder as compensation for services performed as an employee of the S corporation are subject to employment taxes. This differing treatment creates an incentive for shareholders of closely-held S corporations to receive more of their compensation in the form of profit distributions and less in the form of salary. The IRS has aggressively attacked unreasonably low salary payments to S corporation shareholders-employees and has successfully recharacterized them as wages subject to employment taxes.15
An S corporation is treated as a partnership for purposes of applying the fringe benefit rules, with each shareholder owning more than 2 percent treated as a partner.16 Any fringe benefits paid to a shareholder owning more than 2 percent of the corporation is treated like partnership guaranteed payments and must be reported on the shareholder’s Form W-2. The S corporation may take a corresponding deduction for the cost of fringe benefits paid to shareholders with more than 2 percent interest in the corporation. See [PARTNERSHIP] for the fringe benefit rules that apply to partners.
State-Level Franchise Tax Issues
Although a full discussion of state law tax consequences of choice of entity is beyond the scope of this guide, capital-based franchise taxes should be given careful consideration when choosing a corporate entity. In many states, corporations are subject to franchise tax, making the corporate form more costly than other alternatives, such as limited liability companies. Consideration of this issue at the time of formation can prevent detrimental tax consequences that could arise if the organization later decides to convert to limited liability company status.
- Treas. Reg. § 301.77-1-2(b)(1), (3).
- I.R.C. § 1366(a)(1); Treas. Reg. § 1.1366-1(a); I.R.C. §1377(a)(1)
- See I.R.C. §§ 1374; 1366.
- Unlike C corporations, S corporations do not generate earnings and profits. Earnings and profits are only a concern if they are carried over from a period when the S corporation was a C corporation or if the S corporation acquires assets from a C corporation in a tax-free transaction.
- I.R.C. § 1375(a).
- I.R.C. § 1362(d)(3).
- I.R.C. § 1361(b)(1)(A).
- I.R.C. § 1361(b)(1)(B).
- I.R.C. § 1361(b)(1)(C); Treas. Reg. § 1.1361-1(g)(1)
- Treas. Reg. § 1.1361-1(l).
- I.R.C. § 1361(c)(4).
- Treas. Reg. § 1.1361-1(l).
- Treas. Reg. § 1.1361-1(l)(2)(iii).
- I.R.C. § 1014.
- See Rev. Rul. 74-44, 1974-1 C.B. 287; Joseph Radtke, S.C. v. United States, 712 F. Supp. 143 (E.D. Wis. 1989) Dunn & Clark, P.A. v. Comm’r, 853 F. Supp. 365 (D. Idaho 1994); Priv. Ltr. Rul. 95-30-005 (April 26, 1995).
- I.R.C. § 1372.