Guide to S Corporations

By Elspeth Crawford

Basics

An S corporation is a corporation created under state law that elects to be taxed under Subchapter S of the Internal Revenue Code. This election results in an S corporation being treated as a pass-through entity for federal income tax purposes, the profits and losses of which pass through to the shareholders rather than being taxed to the corporation.

Apart from the manner in which it is taxed, an S corporation is indistinguishable from a C corporation. A S corporation is formed in the same manner as a C corporation, its shareholders enjoy the same limited liability protections, and it is managed in the same manner.

In order to qualify as an S corporation for federal income tax purposes, the corporation must file an election with the Internal Revenue Service. This election can be revoked at any time by the consent of the shareholders. It may also be terminated under certain circumstances.

If an S corporation election is in effect, profits and losses of the corporation are passed through and taxed on the individual returns of the shareholders. All shares of stock of an S corporation must have the same rights to dividends and liquidating distributions.

In some states that levy income taxes, S corporations are treated as pass through entities. In other states with income taxes, S corporations are treated in the same manner as C corporations.

Owner’s Liability

The treatment of S corporations is the same as that of C corporations from the standpoint of shareholder liability. Making an S corporation election only affects the income taxation of a corporation. It does not affect the limited liability of the corporation's shareholders, who enjoy limited liability to the same extent as shareholders of a C corporation.

Control

S corporations the same as C corporations from the standpoint of management and control. Making an S corporation election only affects the income taxation of a corporation. It does not affect the management of the corporation.

Transferability of Ownership Interests

An S corporation is the same as a C corporation from the standpoint of transferability of ownership interests. But there are limitations on the types and number of persons that may hold stock of an S corporation. If stock of an S corporation is transferred to a person other than an individual (who is not a nonresident alien), estate, or trust qualified to hold S corporation stock, or if a transfer results in stock being held by more than 100 shareholders, the S corporation election will be terminated. Consequently, S corporations typically have in effect buy-sell agreements or other arrangements that restrict transfers of stock that would cause termination of the S corporation election.

The same securities law and control issues that affect the transferability of stock of C corporations also affect S corporations. As with a C corporation, an S corporation's existence that is not affected by the death, dissolution, incapacity, or bankruptcy of a shareholder, although its S corporation election could be jeopardized if stock ends up in the hands of a person who is not qualified to be an S corporation shareholder. The existence of an S corporation, like a C corporation, is not affected by the resignation of an officer or director.

Organizational and Maintenance Costs

An S corporation the same as a C corporation from the standpoint of the formalities required for creating and operating the corporation. The only difference between an S corporation and a C corporation in this regard relates to income tax return filing requirements. An S corporation must file an information return for federal income tax purposes even though its income or losses are passed through and taxed to its shareholders, whereas a C corporation files its own income tax return and pays tax on its own income. For state income tax purposes, an S corporation may be treated as a pass-through entity or may be treated the same way as a C corporation.

Tax Attributes

A corporation can avoid the double taxes that are imposed on profits of a C corporation if the corporation elects to be taxed as an S corporation. An S corporation is taxed something like a partnership. The corporation files an information return for federal income tax purposes, but its income or loss is passed through and is taxed to the shareholders of the corporation. The deduction of losses by S corporation shareholders is subject to the passive loss limitations and at risk rules.

As with a limited liability company (LLC), an S corporation combines limited liability with pass-through income tax treatment. The taxation of S corporations and limited liability companies is, however, not the same in all respects. An LLC with more than one member is taxed as a partnership and therefore provides three tax advantages not shared by S corporations:

• Liabilities of the LLC are counted in determining the basis of its members in their ownership interests, thus increasing the amount of the entity's losses they are allowed to deduct;
  
  
• Special allocations of income, loss, and other tax items can be made, and distributions may be made to members in manner that is disproportionate to their ownership interests; and
  
  
• The tax basis of an LLC can be increased in certain circumstances involving the death of an LLC member or the transfer of a member's interest. 
  

On the other hand, S corporations can provide employment tax advantages. Shareholders are subject to FICA tax only on salaries or other compensation paid to them—undistributed S corporation income and dividends paid by S corporations are not subject to employment tax. In contrast, each member of an LLC who is an individual must, in most cases, pay self-employment tax each year on his or her share of the LLC's income, whether or not the income is distributed to the member. The only members who are exempted are those in manager managed LLCs who do not materially participate in the business of their LLCs.

An S corporation can also provide favorable tax treatment in connection with the development and sale of real property. If a shareholder sells undeveloped property to an S corporation, the shareholder will recognize capital gain or loss. If the corporation develops and then sells the property, the incremental increase in value created by the corporation's development services will generate ordinary income that will pass through and be taxed to the shareholder of the corporation. But the shareholder will not be subject to employment taxes on the income, except to the extent it is distributed in the form of compensation.

If a partner or member sells development property to a partnership or LLC, any gain realized will be ordinary income under I.R.C. § 707(b) if the person owns more than 50% of the capital or profit interests in the purchasing entity. Moreover, the person will be subject to self-employment tax on any income realized on the development of the property. Consequently, the after-tax return realized by the original owner from the sale, development, and resale of the property will not be as great with an LLC as it would be with an S corporation.

It should be noted that the problem of double taxation of C corporation's gains on sales of assets is not solved by having the corporation make an S corporation election. If a C corporation makes an S corporation election in anticipation of a proposed sale, it will be subject to built-in gains tax, which results in double tax at the highest rates. If the corporation is already an S corporation, there will not be a double tax on property distributions. There will, however, be a single tax.

The inability to withdraw assets from an S corporation without tax prevents business organized in this form from being converted to other forms of entity, such as limited liability companies without tax consequences. On the other hand, rearrangement of the corporate structure or ownership of a S corporation may be possible through several types of tax-free reorganizations so long as the assets remain in corporate solution.

Advantages

• All shareholders enjoy limited liability for obligations and liabilities of the S corporation.
  
  
• Stock is freely transferrable, subject to limitation by agreement and subject to the limitations on the types and numbers of persons who may be shareholders of an S corporation.
  
  
• An S corporation can have perpetual existence unaffected by the death, dissolution, insanity, or bankruptcy of shareholders or the transfer of shares.
  
  
• An S corporation has centralized management, and there is extensive law regulating corporate operations and decision making.
  
  
• Business profits are subject to only one tax, at the individual shareholder level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
  
  
• Losses are available on the shareholders' personal income tax returns and can offset other income (subject to the passive loss rules and at risk rules).
  
  
• Sales and redemptions of stock generally result in realization of capital gains by the shareholder and not ordinary income.
  
  
• Unlike an LLC or other unincorporated entity, an S corporation can issue stock options to employees as part of their compensation package.
  
  
• S corporation income is not subject to employment tax. This allows the corporation to defer or avoid employment taxes, which is something entities taxed as partnerships cannot do or can accomplish only in part. 
  

Disadvantages

• Strict qualification rules must be met on a continuing basis, which among other things limit the number and types of shareholders.
  
  
• Formalities are required for organization and operation of an S corporation.
  
  
• Qualification is required for doing business in other states.
  
  
• Regular reporting to governmental entities is required.
  
  
• Stock transfers are subject to securities law regulation.
  
  
• The distribution of property by an S corporation to its shareholders is generally a taxable event for income tax purposes as to the corporation. Thus, withdrawing property from an S corporation can be expensive from a tax standpoint, and an S corporation cannot be converted into a partnership, limited partnership, or limited liability company without gain or loss recognition.
  

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