S Corporations: The Basics

An S Corporation is the same as any other corporation except for the manner in which it is taxed. S Corporations generally do not pay United States federal corporate income tax and do not benefit from their losses at the corporate level. Instead, income, deductions, losses and other tax items pass through to their stockholders for federal tax purposes. Consequently, profits earned by an S Corporation will be taxed only once, at the stockholder level.  Similarly, losses of an S Corporation flow through to its stockholders and may be deducted by the stockholders on their individual tax returns (subject to certain significant limitations).  Profits, deduction, losses and other tax items are required to be allocated based on share ownership.  The stockholders must include the profits as income in the tax year in which the S Corporation’s year ends (whether or not any amounts are distributed to stockholders).  As such, distribution of earnings by an S Corporation to its stockholders is generally taxed only once, at the stockholder level.  In contrast, a similar distribution by a corporation other than an S Corporation will be taxed twice; the C Corporation must pay federal corporate income tax on profits when earned and the stockholders must pay personal tax if the C Corporation makes distributions to its stockholders.

For a general overview of the different types of business entities, see my other article Choosing the Correct Business Entity: The Basics. For a quick reference, check out the chart in our article Comparison of C Corp, S Corp and LLC Entity Types.

When you might want to elect S Corporation status

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 utilize the loss deductions on their personal income tax returns.  There are substantial requirements and limitations upon the availability of the S Corporation election and the allocation and deduction of S Corporation losses by its stockholders.

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 domestic (i.e., a US) 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).

The limitation on eligible S Corporation stockholders will prevent any business that intends to raise equity capital from venture capital funds, corporations or other institutional investors from qualifying as an S Corporation. The law prohibits most entities from being shareholders of S Corporations. Unlike S Corporations, limited liability companies (“LLCs”)/partnerships offer a greater degree of flexibility allowing any entity to be a partner in a partnership and to issue multiple classes of stock with different rights to distributions and liquidations. In addition, the requirement that an S Corporation can have only one class of stock not only affects the company’s ability to raise capital, but also eliminates the technique most widely used by businesses that desire to issue inexpensively priced common stock to service providers.  Most corporations that raise money from outside investors issue two classes of stock: convertible preferred stock to the investors and common stock to employees.  The common stock is typically issued at a fraction of the price of the preferred stock because it lacks the liquidation, dividend, voting and other preferences that the preferred stock possesses.  Since an S Corporation can only have one class of stock, it must issue the common stock to employees at the same price paid by the investors (unless sold to the founders well in advance of the sale to the investors). Additionally, only C Corporations can issue stock that qualifies as qualified small business stock (“QSBS”). As such, stock that is issued by an S Corporation will not transform into QSBS if the corporation terminates its S Corporation election and becomes a C Corporation. Although LLC/partnership equity does not itself qualify as QSBS, LLCs typically can convert to C Corporation form on a tax-free basis, with the successor C Corporation’s stock qualifying as QSBS if all eligibility requirements are met at that time. Accordingly, the S Corporation 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.

Process for electing S Corp status

A qualified corporation may elect to be taxed as an S Corporation by 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 Corporation status is to be effective or at any time during the preceding taxable year.  Failure of a corporation to meet all of the S Corporation requirements each day of the year, can cause termination of an S election, which in turn can create numerous tax issues, including with respect to income allocation and stockholder distributions.