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SUB S TAX STATUS FOR
CORPORATIONS AND SOME BASIC STRUCTURAL RESTRICTIONS
INTRODUCTION:
As seen in our web
article on
Limited Liability Companies the use of a structure giving
the owners limited liability to creditors is highly recommended for both
start up and established companies.
One aspect of the
standard corporation is the fact that along with limited liability comes
a separate taxable entity which pays its own taxes and insulates the
owners from the tax burden and tax status of the operating entity.
In some cases,
especially during start up periods when companies often lose money, the
owners do not want to isolate themselves from the operating company’s
tax situation since they would like to utilize those losses for their
personal tax situation. They want the limited liability but wish to pay
taxes as if there was no separate entity at all.
Both limited
liability companies and Sub S corporations were created to allow limited
liability with no separate taxable entity. This article shall discuss,
however, some structural limits applicable to the structure of Sub S
corporations if they want to maintain their Sub S status.
SUB S CORPORATIONS
A new corporation
that wishes to have Subchapter S status must elect that status close
upon its formation and a good accountant is recommended before such a
decision is made. While the status can be abandoned at a later time, it
requires shareholder consent and could have significant tax
consequences.
To be effective for
a current year, a corporation must file its S corporation election not
later than two months and fifteen days after the first day of the
taxable year. For purposes of determining when the S corporation must be
made a new corporation’s taxable year is deemed to begin on the
earliest date it has shareholders or acquires any assets or begins
to do business.
Essentially, a
Subchapter S corporation is taxed as a partnership, with each owner
paying taxes or gaining losses on their tax return in proportion to the
ownership percentage they own. Thus, during periods of loss, those
losses can be passed through on a personal return. Of course, during
periods of gain, each shareholder must report their share of income on
their personal return.
The basic corporate
structure is identical between a standard corporation which has a
separate tax entity (Subchapter C corporations) and a subchapter S
corporation, but the Internal Revenue Service (“IRS”) has passed
restrictions on the nature of the stock and structure in the Sub S
corporation which, if not adhered to, can result in losing the Sub S
status, often retroactively with disastrous tax consequences on the
owners.
STRUCTURAL RESTRICTIONS:
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NUMBER OF SHAREHOLDERS:
There can be no more than one hundred shareholders in a Sub S
corporation. Note, however, that in counting shareholders, spouses
holding shares are counted as one. (IRC Section 1361 (b) (1) and (c)
(1).
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KINDS OF SHAREHOLDERS:
Only the following persons may hold stock in an S corporation:
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Individuals
who are citizens or resident aliens may own shares (nonresident
aliens may NOT own stock.)
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Estates;
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Special
types of Trusts
-
Another S
corporation (but only if the other S corporation is the sole
shareholder)
-
A
partnership, but only if the partnership is acting as a mere
nominee for a person who qualifies as an S corporation
shareholder;
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Tax exempt
charitable organizations.
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CLASSES OF STOCK:
An S corporation can only have one class of stock outstanding
(common) so that each shareholder has the same rights to share in
the profits and assets of the corporation. However, certain shares
may have exclusive or greater voting rights than others and this may
include giving some shareholders a veto power over share transfers
by other shareholders (buy and sell agreement.) Other than voting
rights, however no distinctions may exist among the shares or
shareholders, including priorities as to dividends, liquidation
rights, etc.
CONCLUSION:
It is readily
apparent that the decision to go Sub S or not is one that must be made
only after close consultation with tax and legal experts since the
ramifications in terms of both power within the company and tax
consequences to the shareholders can be major. And the problems can be a
bit more subtle than the neophyte owner may realize. A typical power
play in a small company may suffice to show the dangers inherent in
making the wrong decision.
It is not uncommon
for owners to have a falling out and to become rivals or bitter enemies.
Assume one of those owners owns a minority position in a Sub S
corporation. The other owner, in effective control of the company offers
to buy him out and is refused. The controlling shareholder, angry, has a
perfect weapon.
He makes sure the
company makes a lot of money.
He does not allow
dividends or other distributions to be made. He does give himself a
raise since he will be facing increased taxes due to the rising income.
However the other shareholder, no longer working for the company, and
unable to force the company to employ him, faces taxation on his
proportionate share of the company’s taxes…without money being
distributed to him.
This power play,
seen by this office many times, eventually forces the minority
shareholder to sell for any price he can get and in one case we saw the
minority shareholder give the stock back to the corporation to avoid
further taxes…but faced gift taxes in doing that!
So, take the time to
get good advice and create appropriate structures for your own
protection before blithely deciding on Subchapter S status.
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