S-Corps
S-Corps
What is an S-Corporation? Answer: it is just like any other corporation, except for how it is taxed. Regular C-Corps pay their own taxes, and the owners pay taxes on the disbursements from the corporation. S-Corporations, however, typically do not pay federal corporate income tax, as both profits and losses get passed through to the owner(s).
Instead, income, deductions, losses and other tax items pass through to the stockholder(s) for federal tax purposes. Profits earned by an S-Corporation will be taxed only once at the owner/stockholder level. The same is true for losses. They flow through to the owner/stockholders such that those losses can be claimed as deductions on the stockholders’ tax returns in most instances. These profits and losses and other tax items are allocated to the owners/stockholders based on the percentage ownership in the S-Corp and they must be included in the owners’ tax return in the year incurred.
C-Corporations, on the other hand, must pay federal corporate income tax on profits when earned and the stockholders must also pay personal tax if the C-Corporation makes distributions to its stockholders. That’s why many small businesses are S-Corps.
Stockholders generally elect S-Corporation status when the corporation is profitable and distributes substantially all of its profits to the stockholders, or when the corporation incurs losses and the stockholders wish to take the loss deductions on their personal income tax returns. But there are limitations on when you can use an S-Corp.
Qualifications for S-Corp status impose important limitations. To qualify for S-Corporation status, a corporation must satisfy the following requirements:
(i) the corporation must be a U.S. corporation;
(ii) the corporation must have no more than 100 stockholders, all of whom are individuals, certain tax exempt organizations, qualifying trusts, or estates, and none of whom are nonresident aliens;
(iii) the corporation must have only one class of stock (although options and differences in voting rights are generally permitted).
S-Corps cannot raise equity capital from venture capital funds, corporations or other institutional investors without losing S Corporation status.
Unlike S-Corporations, limited liability companies (“LLCs”) taxed as partnerships offer more flexibility and allow an entity to be a partner and to issue multiple classes of membership interests with different rights to distributions and liquidations.
Additionally, only C-Corps can issue stock that qualifies as qualified small business stock (“QSBS”). As such, stock that is issued by an S-Corp will not transform into QSBS if the corporation terminates its S-Corp election and becomes a C-Corp. Although LLC/partnership equity does not itself qualify as QSBS, LLCs typically can convert to C-Corp status on a tax-free basis, with the successor C-Corp’s stock qualifying as QSBS if all eligibility requirements are met at that time.
Because of all of this, S-Corp status is most commonly used for family or other closely owned businesses that obtain capital from their individual stockholders and/or debt from outside sources and do not provide equity incentives to their employees on any significant scale. It is easy to elect S-Corp status by the corporation filing Form 2553 with the Internal Revenue Service, together with the consent of all the stockholders. This S-election must be filed on or before the 15th day of the third month of the taxable year of the corporation for which S-Corp status is to be effective or at any time during the preceding taxable year. Failure of a corporation to meet all of the S-Corp requirements each day of the year can cause termination of an S-election, which in turn can create tax headaches, including regarding income allocation and stockholder distributions.
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EPPS & COULSON, LLP
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