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:
The corporation must be a domestic corporation. Foreign entities cannot qualify for S status.
Must Be An Eligible Corporation
Ineligible corporations are any of the following corporations:
- Foreign corporations
- Certain banks, and
- Insurance companies
Subsidiariaries of an S corporation called qualified subchapter S corporation subsidiaries (QSSS) are eligible S corporations.
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:
- 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 Limitations 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. In contrast, the pass through of income from an LLC is automatically treated as subject to social security taxes. These social security and medicare taxes may be more than 15% of income. As a result S corporations may offer savings in social security taxes that LLC cannot provide.
Caveat: The IRS however is aware of this tax strategy. As a result they may argue that the salary paid to S shareholders is unreasonably low. For more on these issues review "Reasonable" Compensation: IRS Auditors Favorite Issue
Making the S Election
For the election procedure for obtaining S status please see the article entitled S Corporation Election.
One Size Does Not Fit All
Before choosing an S corporation, an LLC or a regular C corporation or some other entity, each particular situation needs to be analyzed.
The above provides only an overview of the issues involved and the requirements for qualifying and maintaining an S corporation.
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.
Copyright © 2011, Steven J. Fromm