Forming a business entity as a corporation comes with a slew of benefits. The biggest upside is that the corporate entity provides a shield protecting the individual shareholders personally from liabilities against the business. For example, if the corporation is sued and the plaintiff obtains a large judgment, then the plaintiff is limited to collecting the assets of the corporation only. The judgment would not extend to collecting against any individual shareholder’s house, personal property or bank accounts. Other benefits of being a corporation include durability and perpetuity, meaning that the business will survive the death of its owners as their shares can be assumed by the stockholder’s legal heirs or sold to another buyer. Finally, a corporation is a more attractive entity than a sole proprietorship, partnership or even a limited liability company for capital investors to pour money into so the corporation can grow.
However, there are some drawbacks to being a corporation. There are more stringent recordkeeping requirements than other business entities such as minutes from shareholder meetings, tracking stock certificates, and managing distributions of dividends. In addition, regular corporations have the drawback of being subject to double taxation. Any profits at the corporate level are subject to the flat corporate tax of 21% imposed by the Tax Cuts and Jobs Act of 2017. In addition, those profits are taxed again in the hands of the individual shareholders that must pay income taxes on the dividends. At the end of the day, the same amount of revenue may be subject to more federal taxes under the corporate model than it would have been under a sole proprietorship or a partnership.
Fortunately, the Internal Revenue Code allows an opportunity for a tax break by classifying two types of corporations: C-Corporations and S-Corporations. A C-Corporation is the classic corporate structure where the corporation is a distinct entity and proceeds are subject to double-taxation. A S-Corporation is a small business corporation that, if eligible, is treated as a “pass-through” entity where proceeds are taxed once in the hands of the shareholders. However, all of the benefits of a corporate shield for the individual shareholders against civil liability is in full force and effect. So what does it take to become a S-Corporation?
To be qualified as an S-Corporation under the Internal Revenue Code, all of the following is required:
- There are no more than 100 shareholders. 26 U.S.C. §1361(b)(1)(A).
- There are no shareholders who are not an individual, estate or grantor trust. 26 U.S.C. §1361(b)(1)(B).
- Husbands and wives, all members of a family (and their estates) are treated as one shareholder for the purposes of counting shareholders. 26 U.S.C. §1361(c)(1)(A).
- Trusts may be shareholders if they are treated as owned by an individual who is a U.S. citizen or resident, or it was created immediately before death or after as a testamentary trust for a 2-year period, or if it was created primarily to exercise the voting power of stock transferred to it, or it is an electing small business trust, or the trust constitutes an IRA in the case of a bank or a depository institution holding company. 26 U.S.C. §1361(c)(2)(A).
- If the trust was created shortly before death or afterwards in a testamentary trust arising out of a will, the estate of the deemed owner or testator shall be treated as the shareholder. 26 U.S.C. §1361(c)(2)(B).
- An eligible estate also includes the estate of an individual arising under the bankruptcy code. 26 U.S.C. §1361(c)(3).
- An organization that is a 401(a) or 501(c)(3) entity may be a shareholder of an S-Corporation. 26 U.S.C. §1361(c)(6).
- There are no shareholders that are non-resident aliens. 26 U.S.C. §1361(b)(1)(C).
- There is no more than one class of stock. 26 U.S.C. §1361(b)(1)(D).
- The small business corporation is NOT one of the following “ineligible corporations”:
- A financial institution which uses the reserve method of accounting for bad debts. 26 U.S.C. §1361(b)(2)(A).
- An insurance company. 26 U.S.C. §1361(b)(2)(B).
- A domestic international sales corporation. 26 U.S.C. §1361(b)(2)(C).
A small business corporation may elect to be an S-Corporation by a vote of all of its shareholders. 26 U.S.C. §1362(a)(1). An election to become an S-Corporation is only valid if ALL shareholders in the corporation on the day the election is held consent to it. 26 U.S.C. §1362(a)(2). An election may be made to become an S-Corporation for any tax year:
- At any time during the preceding tax year. 26 U.S.C. §1362(b)(1)(A).
- OR at any time during the current tax year on or before the 15th day of the 3rd month of the current tax year. 26 U.S.C. §1362(b)(1)(B).
The corporation must submit Form 2553 – Election by a Small Business Corporation signed by all the shareholders to the IRS to officially convert to S-Corporation status.
WHAT IS THE EFFECT OF BEING A S-CORPORATION?
The immediate effect of becoming an S-Corporation is that the small business corporation is no longer subject to corporate taxation. 26 U.S.C. §1363(a). This means that all of the profits and losses “pass through” to the shareholders. To determine the shareholder’s tax liability for the tax year, the S-Corporation shall take “into account the shareholder’s pro rate share of the corporation’s items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and nonseparately computed income or loss.” 26 U.S.C. §1366(a)(1). “[N]onseparately computed income or loss” means gross income minus the deductions allowed to the corporation, determined by excluding the corporation’s deductions not subject to separate treatment by the shareholders. 26 U.S.C. §1366(a)(2). The character of any item included in the shareholder’s pro rata share is treated in the same manner as if it was in the hands of the corporation. 26 U.S.C. §1366(b).
Shareholders of S-Corporations will receive Schedule K-1 from the corporation that states their share of the corporate income, losses, deductions and credits that flow to them for purposes of their own federal tax returns. Any income tax assessed is done so at their individual income tax rate. However, the S-Corporation itself is responsible for paying taxes on certain built-in gains and passive income at the entity level.
However, shareholders providing services to the corporation as officers, managers or employees are treated as employees of the corporation for federal employment tax purposes and are required to be paid “reasonable compensation” in the form of wages subject to employment taxes. A shareholder-employee cannot hope to just take all income in the form of dividends, payment of personal expenses, or loans at capital gains rates and hope to avoid any tax liability at ordinary rates. If the shareholder-employee is entitled to corporate income beyond the reasonable compensation paid, then this can take the form of dividends at capital gains tax rates on their personal tax returns.
WHEN IS S-CORPORATION STATUS TERMINATED?
The S-Corporation status of a small business corporation can be removed under the following circumstances:
- Election Held To Revoke – S-Corporation election can be revoked by vote “only if shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made consent to the revocation.” 26 U.S.C. §1362(d)(1)(B). A revocation made on or before the 15th day of the 3rd month of the tax year is deemed effective on the first day of the current tax year. 26 U.S.C. §1362(d)(1)(C)(i). A revocation made after the 15th day of the 3rd month of the tax year is deemed effective on the first day of the following tax year. 26 U.S.C. §1362(d)(1)(C)(ii).
- Corporation Ceases To Be Small Business Corporation – S-Corporation status is terminated whenever (at any time on or after the 1st day of the 1st taxable year for which the corporation is an S-corporation) such corporation ceases to be a small business corporation. 26 U.S.C. §1362(d)(2)(A). This termination is effective on or after the date of cessation. 26 U.S.C. §1362(d)(2)(B).
- Corporation Has Passive Investment Income And Accumulated Earnings And Profits For 3 Consecutive Years – S-Corporation status is terminated whenever the corporation has accumulated earnings and profits (e.g. not distributed to shareholders) at the close of each three consecutive tax years AND has gross receipts for each tax year of which more than 25% is passive investment income. 26 U.S.C. §1362(d)(3)(A)(i). This termination is effective on the first day of the following tax year beginning after the third consecutive year referred to above. 26 U.S.C. §1362(d)(3)(A)(ii). For a “consecutive prior year” to be counted, the corporation must have been a S-Corporation during that prior tax year. 26 U.S.C. §1362(d)(3)(A)(iii).
If a small business corporation made an election to become an S-Corporation and that election was subsequently terminated, that corporation will not be eligible to again make an election to become an S-Corporation until 5 years after the first tax year begins of which the termination was effective. 26 U.S.C. §1362(g).
IS IT WORTH BECOMING AN S-CORPORATION?
There are many positive benefits to becoming a S-Corporation, but shareholders should be aware of some possible drawbacks associated with making that election:
- Formation and Expense: Before electing S-Corporation status, the business must first be incorporated as a corporation at the state level by filing Articles of Incorporation with the appropriate state office, obtaining a registered agent and paying all required fees. The corporation will also have to invest in other formalities such as forming a charter and bylaws, issuing stock certificates and keeping minutes for shareholder meetings. Many states will also require annual reports and ongoing franchise fees. Although these costs are not excessive, it is generally more time and expense involved than if it was a sole proprietorship or partnership.
- More Scrutiny By IRS: Due to the benefits being conferred by the Internal Revenue Code, the IRS will take a closer look at the S-Corporation than C-Corporations or even partnerships to ensure that it comports with the law. Specifically, the IRS likes to scrutinize if “reasonable compensation” for shareholder-employees paid in wages are actually being paid in the form of dividends to avoid employment tax liability. In addition, the IRS will not hesitate to terminate S-Corporation status if the business fails to qualify in any given tax year.
- Little Flexibility In Allocating Income And Loss: Since there is only one class of stock, an S-Corporation can only allocate income or losses to shareholders based on their stock ownership (unlike partnerships or LLCs where allocation is governed by the operating agreement). Shareholders cannot deduct losses on their personal tax returns from S-Corporations unless the stock is worthless or sold at a loss.
- Fringe Benefits Are Taxable: Fringe benefits provided by the corporation to shareholder-employees are taxable if they own more than 2% of the corporation.
The decision to incorporate into a S-Corporation should be made in consultation with legal and tax counsel to see if it is right for you. Fortunately, our law firm is able to provide both of those services with our skilled attorneys and tax professionals. If you have questions about S-Corporations or need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.