With the benefits of filing as an S corporation (S corp), it would seem likely that most companies would take care to prevent the loss of this status. Yet, many fail to take precautionary steps to avoid the termination of the S corp status. While some of the steps outlined in this article can be complex, the benefit of avoiding double taxation can also make them worthwhile.
A Review of the S Corporation Status
The S corporation is status that can be created through an IRS tax election for eligible domestic corporations. As mentioned above, being treated as an S corporation offers a means to avoid double taxation (i.e. taxed once as a corporation and subsequently as shareholders). It is also important to note that liability protection is limited for S corps. The S corporation does not necessarily protect the owners or shareholders from all litigation. Nonetheless, the S corporation differs from a C corp in that its profits and losses can pass through to a personal tax return. That means that the shareholders are taxed but the business is not.
Protecting Your S Corp Status
Monitor stock issues and track the number of shareholders. An S corp is limited to 100 shareholders. Having more than 100 shareholders at any point during a year will result in the termination of the status. Having a shareholder agreement can help to prevent any transfer of shares that could result surpassing this limitation.
Monitor the types of shareholders. Only certain types of shareholders are permitted for S corps. Prevent the loss of your status by ensuring your shareholders are limited to individuals with U.S. citizenship or residency; estates; and specific types of trusts. Remember that nonresident aliens, partnerships, corporations, and other types of trusts are prohibited. Again, a shareholder agreement can be an effective tool to prevent the transferring shares to ineligible parties.
Monitor stock classes. The basic rule of an S corp is that it can only have one class of stock. All outstanding shares must provide identical rights. While having voting and nonvoting stock can be permissible, the governing rule is complicated and deserves additional attention when drafting agreements.
Monitor passive investment income. An S corporation status is terminated if more than 25 percent of gross receipts are from passive investment sources for three consecutive years and there is C corporation Accumulated Earnings and Profits (AE&P) at the end of each year. To prevent the loss of the S corp status, the company should track passive investment income. One way of preventing this loss of status if it appears that passive income will surpass the 25 percent limitation is to distribute AE&P to shareholders. Alternatively, the S corp could reduce passive investment income, increase other income, or both.
While the above steps can help to prevent an accidental loss of the S corp status, they only apply if the appropriate tax elections are filed properly with the IRS. For additional information or to have a review of the tax elections filed for your business, contact Sandy Smith, Tax Partner with Daszkal Bolton, at email@example.com.