This article presents an overview discussion of the taxation of S corporations and their shareholders.
While S corporations are corporations for purposes of state law, they are taxed much like partnerships for federal (and, in many cases, state) income tax purposes. There are several major federal income tax advantages of operating as an S corporation instead of as a regular C corporation. These advantages include:
- A single level of tax. The income of an S corporation is generally subject to just one level of tax. In other words, the income generally is taxed only to the corporation's shareholders. In contrast, a C corporation pays tax on its earnings, and its shareholders pay a second tax when corporate earnings are distributed to them in the form of dividends.
- The availability of losses. Shareholders of an S corporation generally may deduct their share of the corporation's net operating loss on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation's earnings. This pass-through of an S corporation's losses to its shareholders makes the S corporation form particularly suitable for start-up businesses that are expected to generate losses during their initial stages.
- Income splitting. S corporations can serve as excellent vehicles for splitting income among family members through gifts or sales of stock.
Although operating as an S corporation offers many significant tax benefits, there are also some significant disadvantages associated with electing S status. The primary disadvantages are:
- The exclusion for up to 50% of the gain on the sale of "qualified small business stock" does not apply to the sale of stock in an S corporation.
- Fewer tax-free fringe benefits may be provided to shareholder-employees of S corporations than to shareholder-employees of C corporations.
- Stock in an S corporation can only be transferred to eligible shareholders (individuals, estates, and certain trusts; certain pension plans and charitable organizations are also eligible for tax years beginning in 1998) and an S corporation cannot have more than 35 (75 for tax years beginning in 1997) shareholders. These limitations restrict the sources and amount of equity capital.
- Estate planning for shareholders is generally more complicated when an S corporation is involved.
- Tax rates applicable to many individuals are higher than the rates that would apply to a C corporation at the same income level.
- Employee stock ownership plans are not available to S corporations; ESOPs can be used after 1997, but some of their tax advantages are not available to S corporations.
Not all corporations may elect S status. The election is available only to qualifying "small business corporations." A corporation must formally elect to be taxed as an S corporation by filing Form 2553, "Election by a Small Business Corporation," with the IRS. An S corporation's taxable income must be computed in order to determine the items of income or loss to pass through to the shareholders.
An S corporation's taxable income generally is computed in the same manner as that of a partnership. Thus, items of income, gain, loss, deduction and credit, the separate treatment of which could affect the tax liability of a shareholder, must be passed through separately to each shareholder. The tax character of these items is determined at the corporate level, and they retain their character when passed through to the shareholders.
An S corporation that was once a C corporation may be subject to one or more of three separate taxes (e.g., the "built-in gains" tax). This rule is an exception to the general rule that S corporations are not subject to tax.
Items of income, gain, loss or deduction that pass through to a shareholder are reflected in the basis in his or her stock (and, in some cases, in debt - if any - that the corporation owes to the shareholder) and, where the corporation has earnings and profits, its "accumulated adjustments account." These adjustments are made to prevent income that is taxed to the shareholder (when earned by the corporation) from being taxed again at the shareholder level when later distributed.
Once an S election is made, it applies for all succeeding years unless the election is terminated. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation's ceasing to satisfy the eligibility requirements for S status, or by the corporation's failing a passive investment income test. For example, the election terminates if the S corporation's stock is acquired by a nonqualified shareholder (e.g., a corporation) or if the number of shareholders exceeds the maximum permitted. The election terminates on the day the eligibility requirement is violated.
Liquidation of S Corporation
Unless the corporation is subject to one or more of the corporate-level taxes, only one level of tax (at the shareholder level) is imposed on the liquidation of an S corporation. Gain (or loss) is reported by the distributee-shareholder to the extent the value of the property received in liquidation exceeds (or is less than) his or her stock basis in the corporation (as adjusted for any gain or loss recognized by the corporation upon the liquidation and passed through to the shareholders).
Alternative Minimum Tax
Neither the corporate alternative minimum tax (AMT) nor the environmental tax applies to S corporations. However, the corporation's individual items of tax preference and AMT adjustment must be passed through separately to its shareholders. The adjusted current earnings adjustment, which applies to C corporations under the AMT, does not apply to S corporations or their shareholders.
State Tax Considerations
The states are not uniform in their treatment of S corporations. A majority of the states closely follow the federal approach, resulting in no state-level corporate tax. Instead, the shareholders are subject to individual income taxes, often in each state where the corporation does business. There are, however, numerous exceptions to federal conformity. For example, many states (including the District of Columbia) do not recognize the special federal tax treatment of S corporations and tax them as regular corporations. Other states have adopted their own S corporation rules that differ significantly from the federal rules, thereby affecting not only the S corporation entity but also its shareholders.
Death of a Shareholder
Upon the death of one of its shareholders, in general, the death will not cause the election to terminate unless the decedent's stock ends up in the hands of an ineligible shareholder, or in the hands of enough shareholders to push the number of shareholders above 35 (75 beginning in 1997).
Although a terminating event could occur, for example, as a result of the estate's distribution of S corporation stock to an ineligible shareholder or multiple shareholders, ownership of the stock by the decedent's estate in itself will not cause termination. The estate qualifies as an eligible S corporation shareholder and is counted as only one shareholder (even if there are multiple beneficiaries). However, if the administration of the estate is unreasonably prolonged, the estate terminates and becomes a trust, which would probably not qualify as an eligible shareholder.
A trust receiving S corporation stock pursuant to the terms of a decedent's will (i.e., a testamentary trust) does qualify as an eligible shareholder for the 60 days beginning on the date the trust receives the corporation's stock. For taxable years beginning after 1996, the grace period is expanded to two years. If the testamentary trust receiving the stock does not otherwise qualify as an eligible shareholder, the corporation's election ends upon expiration of the grace period unless the stock is transferred to an eligible shareholder, the trust seeks court approval to amend trust provisions, or the appropriate disclaimers are executed by trust beneficiaries. It should be noted, however, that trusts established under wills executed prior to 1983 (when a major revision of the Subchapter S rules became effective) are likely not to qualify as eligible shareholders.
There are various ways that pre-death planning can be used to prevent terminating events. First, the decedent's will may specifically bequest the stock to an eligible shareholder. Alternatively, the executor could be authorized by the will to retain or distribute the stock in such a way as to avoid termination.
A shareholder may also execute a buy-sell agreement obligating the estate to sell its stock to an eligible shareholder, or a shareholder agreement that prohibits the transfer of the stock to an ineligible shareholder. Moreover, the shareholder can execute an agreement with the corporation to have the stock redeemed upon the shareholder's death. Such a redemption, in fact, may be advisable as post mortem protection against termination if none of the above steps were taken by the shareholder.