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.
1. 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).
2. KINDS OF SHAREHOLDERS: Only the following persons may hold stock in an S corporation:
Individuals who are citizens or resident aliens may own shares (nonresident aliens may NOT own stock.)
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;
Tax exempt charitable organizations.
3. 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.
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.