What is a S-Corporation?

An S-Corporation is the little brother of the regular C-Corporation.

C-Corporations usually:

  1. Preferred business entity for large, publicly traded entities
  2. Has TWO (2) layers of taxation, (a) the corporation pays taxes at the entity level and (b) any shareholders pay dividend taxes on any dividends received from the C-Corporation.

S-Corporation usually:

  1. Utilized by small business owners
  2. Has only ONE (1) layer of taxation – any earnings of the corporation flow through to its owners via a Form K-1.
  3. Earnings flow through to S-Corporation shareholders whether they are distributed or not.

Is an S-Corporation Better than a C-Corporation for Income Tax Purposes?

With the new Tax Cuts and Jobs Act signed by President Trump on December 22, 2017, the income tax analysis is harder than before.

Starting in 2018, C-Corporations pay income taxes at the corporate level at a flat 21% rate, down from a maximum rate of 35%.

In 2018, taxpayers receiving income from flow through entities such as S-Corporations can potentially deduct up to 20% of their income from flow-through entities. This will be subject to certain exceptions and limitations.

Early consensus on the new tax law seems to be that for most taxpayers, S-Corporations and other pass through entities are still slightly ahead of their C-Corporation brothers when it comes to income tax efficiency.

So Does Protecting a S-Corporation Election Still Matter? (Hint – the IRS Has a 3 Year Look Back)

            The IRS DEFINITELY cares if your S-Corporation’s S-Election is busted.

If your S-Corporation fails to qualify as an S-Corporation, IRS has a three year statute of limitations to sue you for:

  1. Corporate income tax
  2. Interest on the corporate income tax that wasn’t paid
  3. Penalties including late payment and failure to file

In other words if your S-Corporation’s S-Election is busted, you could be looking at corporate level income taxes, interest, and penalties on three years worth of returns.  Be sure to file those annual IRS Form 1120S returns. The statute of limitations starts running when the Form 1120S is filed.

If your CPA hasn’t been filing returns for prior year, the IRS can sue you for those returns EVEN IF they are more than 3 years old.  This is because the statute of limitations hasn’t started running on those returns yet.

What are the Requirements to Qualify for the S-Election?

Internal Revenue Code Section 1361 lays out the requirements to qualify as an S-Corporation.

General requirements to qualify as an S-Corp are as follows:

  1. Domestic (US) corporation
  2. Single class of stock
  3. No more than 100 shareholders
  4. Shareholders must be either US citizens or US resident aliens
  5. Most business entities are NOT permissive S-Corporation shareholders (exception: disregarded entities like a single-member LLC)
  6. Most trusts are not eligible S-Corporation shareholders (exception: Grantor Trusts)

Single Class of Shares? Does Each Shareholder Have to Have Voting Rights?

If the only difference in the classes of shares is voting rights, those share classes are considered a single class of shares under IRC 1361(c)(4).

The trouble starts when one class of shares has different ECONOMIC rights than another class of shares.  In order to check these rights always double check the definitions of Class A and Class B in the shareholder agreement and the shareholder ledger.

Other possible pitfalls: (a) debt convertible to equity and (b) stock redemption rights; be sure these provisions don’t create classes of shareholders with different economic rights.

No More Than 100 Shareholders – Family Members Are All 1 Shareholder

The 100 shareholders requirement has a big safe harbor – all members of a family are considered a single shareholder for purposes of counting shareholders.

For these purposes, “members of a family” include a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant.

Non-Resident Aliens not Allowed as Shareholders – Be Careful of Marriages and Changes in Citizenship

The citizenship requirement is typically not an issue when the S-Corporation is set up. The problems start when people begin changing their citizenship, residency, or start marrying non US citizens.

Example:

Meghan is a hard working paralegal at Suits Corporation, an S-Corporation. Meghan is awarded 1 share of Suits Corporation by the corporation’s owner, Harvey, for her many years of service. Harvey verifies that Meghan is a US citizen before issuing the S-Corporation share.  Later, Meghan marries a charming British prince, Harry, and becomes a British citizen. They do not have a prenuptial agreement and Harry receives a community property interest in the S-Corporation share.

Result: The S-Election is busted when the British Prince becomes the owner of a community property interest in Meghan’s 1 share of the Suits Corporation.

Possible fixes?

  1. Premarital agreement ensuring that Meghan’s 1 share in Suits Corporation remained her separate property after marriage.
  2. Meghan and her husband make a § 6013(g) election on their income tax return allowing them to file a joint United States tax return and causing the United States nonresident to be treated as United States resident for S-Corporation purposes.

Avoid Business Entities As S-Corporation Owners

Most business entities are ineligible owners of S-Corporation shares. For example, a C-Corporation is an ineligible owner of S-Corporation shares.

As a general rule, you want S-Corporation shares to be owned by individuals.

Some exceptions include:

  1. Single member LLCs, assuming the LLC owner is an eligible S-Corporation owner
  2. Bankruptcy and Decedent’s estates, for a limited time
  3. Grantor Trusts, discussed below

Exception: Grantor Trusts Are Eligible S-Corporation Owners

A trust is a “grantor” trust for income tax purposes when the taxable income of the trust is forced onto the income tax return of the grantor (maker) of the trust.

As a general rule, a trust is a separate entity for income tax purposes and files its own separate annual income tax return (IRS Form 1041 for trusts and estates).

However, if the grantor of a trust retains certain powers over the trust, including the right to revoke the trust or to substitute assets in and out of the trust, then that grantor is treated as owning the trust for income tax purposes.  The trust will be considered a  “grantor trust” and the income of the trust will be assigned to that grantor’s personal income tax return (IRS Form 1040 for individuals).

But be careful! If any of the Grantors of the Grantor Trust is an ineligible S-Corporation shareholder then the Grantor Trust is an ineligible S-Corporation shareholder.

Takeaway

Be sure to check with your tax advisor and legal counsel before changing the ownership of your S-Corporation to avoid losing the S-Corporation election.  If you have any questions regarding this blog post or the services offered by TCV Law Group, please don’t hesitate to contact us.