Philadelphia Estate Planning, Tax & Probate Attorney Steven J. Fromm & Associates, P.C.

S corporations are regular corporations formed under the laws of the state where incorporated. This provides the usual personal liability protection to its shareholders for corporate debt. What makes S corporation's different than regular corporations (sometimes referred to as C Corporations) is that they elect to be treated as an S corporation under federal and state law. Such an election changes who is taxed on the income of the S corporation and who can report losses from S corporation operations while still providing for insulation from personal liability for corporate debts of shareholders.

Later, when the business is sold, the S corporation is not subject to tax on such sale of its business. The gain on such sale is passed through to its shareholders, thus avoiding double taxation. In a regular C corporation situation double taxation results as the corporation is first taxed on the sale of its business and then its shareholders are taxed on their receipt of the liquidating distributions from such sale. This is one of the major reasons for electing S status and especially in the case where real estate is owned by the S corporation. The bottom line here is that the taxable gain on the business sale will almost always be less than what it would have been had the corporation operated as a regular corporation.

The following provides the basic requirements for qualification of a corporation as an S corporation, operational rules and guidelines under the Internal Revenue Code:

DOMESTIC CORPORATION

The corporation must be a domestic corporation. Foreign entities cannot qualify for S status

MUST BE AN ELIGIBLE COPORATION

Ineligible corporations are any of the following corporations:

Foreign corporations
Certain banks, and
Insurance companies

A subsidiary of an S corporations called a qualified subchapter S corporation subsidiaries (QSSS) is eligible to be an S corporation.

NUMBER OF SHAREHOLDERS

A maximum of 100 shareholders are permitted. Family members may be treated as one shareholder for counting purposes. However, if shares are held jointly by two unrelated shareholders, they are both treated as separate shareholders.

ONE CLASS OF OUTSTANDING STOCK

Voting common and voting preferred are treated as two classes of stock and would result in a loss of S status.

Two classes of common stock are permitted if they differ only as to voting rights but are identical in all other aspects such as rights to dividends, liquidations rights and distributions.

SHAREHOLDERS MUST BE QUALIFIED SHAREHOLDERS

All shareholders of an S Corporation must be either:

Individuals,
Estates or
Certain qualifying trusts and exempt organizations.

Partnerships, LLCs and corporations can not hold stock in an S corporation.

A single member LLC classified as a disregarded entity can qualify as a shareholder of an S corporation.

NONRESIDENT ALIEN IS PROHIBITED SHAREHOLDER

An S corporation may not have a nonresident alien as a shareholder. Individuals who are not US citizens must live in the US to own S corporation stock. Basically each S corporation shareholder must be a U.S. citizen or resident.

PROFIT AND LOSS SHARING ALLOCATIONS and LIMITATION OF LOSSES

The profits and losses may be allocated only in proportion to each shareholder's interest in the company.

An S corporation shareholder cannot not deduct losses which are more than his/her "basis" in corporate stock which equals the amount of
the shareholder's investment in the company plus or minus a few adjustments.

FRINGE BENEFIT LIMITATIONS FOR 2% SHAREHOLDERS

S corporations cannot not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

SOCIAL SECURITY TAX IMPLICATIONS

S corporation shareholders are not subject to self-employment taxes on the allocation of the taxable income from the S corporations. The pass through of income from LLC is automatically treated as subject to social security taxes. These taxes, which may be more than 15% of income, are used to pay your social security and medicare taxes.

Making The S Election

For the election procedure for obtaining S status please see the article entitled S Corporation Election.

SUMMARY

The above provides only an overview of the issues involved and the requirements for qualifying and maintaining an S corporation. Before choosing an S corporation, an LLC or a regular C corporation or some other entity, each particular situation needs to be analyzed. One size does not fit all. So before forming a business entity, a discussion with a tax attorney will avoid costly mistakes and a mismatch of entity for the particular business involved.

“I have always found Steve to be very responsive, accurate and creative in legal matters presented to him. He demonstrates a good business sense. We have collaborated on several highly technical issues over the years. I look forward to our continuing relationship.” Mike Massa, Owner, Klatzkin & Company, LLP, a CPA firm that worked with Steven J. Fromm, November 25, 2008

S CORPORATION: THE BASICS