You likely chose S corporation status (or are considering making an S election) because it represents the best of both corporate and partnership worlds, combining the liability protection of a corporation with many of the tax benefits of a partnership. But these benefits come at a price, and maintaining S status requires some due diligence.
Basic Checklist for S Corporations
First, let’s start with the basics. To qualify as an S corporation, a corporation must meet all the following criteria:
- File Form 2553 — Election by a Small Business Corporation with the IRS
- Be a domestic (U.S.) corporation
- Have no more than 100 shareholders (certain family members are treated as a single shareholder for these purposes)
- Have only “allowable” shareholders
- Have only one class of stock (generally, that means that all stock confers identical rights to distributions and liquidation proceeds; differences in voting rights are permissible)
- Not be an “ineligible” corporation, such as an insurance company, a domestic international sales corporation, or a certain type of financial institution
This checklist highlights the main disadvantages of an S election: limitation on the number and types of shareholders (more on that below), and prohibition of complex capital structures.
Who Can Be a Shareholder?
Partnerships, corporations, and nonresident aliens are not allowed to own shares of an S corporation. Individuals and estates are allowed. A domestic trust is an allowed shareholder if it is any of the following:
- A grantor trust, provided it has only one “deemed owner” who’s a U.S. citizen or resident and meets certain other requirements
- A testamentary trust established by a shareholder’s estate plan
- A voting trust
- A qualified subchapter S trust (QSST) — one that distributes all current income to a single beneficiary who’s a U.S. citizen or resident, and for which the beneficiary files an election with the IRS
- An electing small business trust (ESBT)
To qualify as an ESBT, (1) all of the trust’s potential current beneficiaries (PCBs) must be eligible S corporation shareholders or nonresident aliens, (2) no beneficiaries may purchase their interests, and (3) the trustee must file a timely election with the IRS. Generally, a PCB is someone who is entitled to distributions or may receive discretionary distributions.
Grantor and testamentary trusts are eligible shareholders for only two years after the grantor dies or the trust receives the stock.
Avoid Inadvertent Termination of S Status
Closely monitor your shareholders and activities to avoid inadvertent termination of your company’s S corporation status. At worst, termination means the loss of substantial tax benefits. At best, it means going through an expensive, time-consuming process to seek relief from the IRS and, if successful, have your S status restored retroactively.
Following are just some of the actions you will need to take to avoid termination:
- Watch the number and type of shareholders, scrutinize the terms of any trusts that hold shares, and ensure that any required elections are filed timely.
- Draft buy-sell agreements that prevent transfers to ineligible shareholders.
- If shares are transferred to an ESBT, make sure all PCBs are eligible shareholders or nonresident aliens.
- If shares are held by grantor or testamentary trusts, track the two-year eligibility period and make sure trusts convert into QSSTs or ESBTs or transfer their shares to an eligible shareholder before the period expires.
- Don’t take any actions that may be deemed to create a second class of stock, such as making disproportionate distributions.
Choice of entity is a decision with implications throughout the life cycle of your business. Whether you are concerned about maintaining your S corporation status or are considering a switch, your CRI advisor can provide guidance and keep you on the right track.