S-Corporation Primer

Primer on S-Corporation Basics, Ownership Restrictions, and Election Considerations

An S-Corporation (S-Corp) is a specific type of corporation that elects a special tax status with the Internal Revenue Service (IRS) in the United States. It’s named after Subchapter S of the Internal Revenue Code, which outlines the regulations for this type of entity.

Key characteristics of an S-Corporation include:

1. Pass-through taxation: Unlike regular C-Corporations, S-Corporations themselves generally do not pay federal income taxes. Instead, profits and losses pass through to the shareholders’ personal tax returns, where they are taxed at individual income tax rates.
2. Limited Liability: Like other types of corporations, shareholders in an S-Corporation have limited liability protection, meaning their personal assets are typically shielded from the corporation’s debts and liabilities.
3. Ownership Restrictions: S-Corporations have restrictions on ownership. They can have a maximum of 100 shareholders, who must be U.S. citizens or residents, certain trusts, or certain tax-exempt organizations.
4. Shareholder Benefits: Shareholders in an S-Corporation can receive distributions, salaries, and benefits. Salaries are subject to employment taxes, while distributions of profits are generally not subject to self-employment taxes.
5. Formal Requirements: S-Corporations must adhere to corporate formalities, including holding regular meetings, maintaining minutes, and following other corporate governance practices.
6. Transferability: S-Corporation shares can generally be transferred, but restrictions might exist based on the corporation’s bylaws or shareholder agreements.

S-Corporations are popular among small to medium-sized businesses because they offer a tax advantage by avoiding the double taxation that occurs in C-Corporations (where the corporation is taxed at the entity level, and then shareholders are taxed on dividends).

To qualify for S-Corporation status, the corporation must meet specific IRS requirements and file Form 2553, Election by a Small Business Corporation. It’s essential to comply with ongoing IRS regulations and corporate formalities to maintain S-Corp status.

Who can own shares in an S-Corporation?

There are restrictions for shareholders in an S-Corporation. The following are generally eligible to own shares in an S-Corporation:

1. U.S. Citizens and Residents: They can own shares in an S-Corporation.
2. Certain Trusts: Qualified trusts, such as electing small business trusts (ESBTs), can hold shares.
3. Other S-Corporations: However, not all S-Corporations can own shares in other S-Corporations.
4. Certain Tax-Exempt Organizations: Some tax-exempt organizations may be eligible shareholders.

However, certain entities are ineligible to own shares in an S-Corporation. These include:

1. Non-Resident Aliens: Non-resident aliens cannot be shareholders in an S-Corporation.
2. C Corporations: Generally, other corporations, partnerships, and non-eligible entities cannot be shareholders.

Do these ownership restrictions extend to Limited Liability Companies electing S-Corporation taxation?

Limited Liability Companies (LLCs) have their own set of rules and regulations separate from corporations, but they can elect to be taxed as an S-Corporation. This election means the LLC, for tax purposes, will be treated similarly to an S-Corporation by the IRS.

However, certain restrictions that apply to S-Corporations regarding ownership and shareholders also extend to LLCs that elect S-Corporation taxation status. This includes limitations such as:

1. Number and Type of Shareholders: Like S-Corporations, LLCs electing S-Corporation status are subject to the maximum of 100 shareholders, who must be U.S. citizens, residents, certain trusts, or certain tax-exempt organizations.
2. Eligibility of Shareholders: Non-qualifying shareholders, such as non-resident aliens, corporations, partnerships, or ineligible entities, cannot hold shares in an LLC that’s elected S-Corporation status.
3. Tax Treatment: LLCs electing S-Corporation status have pass-through taxation, meaning the profits and losses pass through to the shareholders’ personal tax returns.
4. Corporate Formalities: While LLCs typically have fewer formal requirements compared to corporations, if an LLC elects S-Corporation status, it must adhere to certain corporate formalities similar to those of an S-Corporation.
5. IRS Filing: The LLC must file Form 2553 with the IRS to elect S-Corporation status, just as a corporation does.

It’s important to note that while an LLC can elect to be taxed as an S-Corporation, it doesn’t change the fundamental structure or legal nature of the LLC. The business still operates as an LLC under state law, maintaining limited liability protections for its members.

Before making any such election, it’s advisable to consult with your CPA and/or attorney to understand the implications and ensure compliance with both state and federal regulations for both the LLC and S-Corporation taxation.

Estate Planning: Do S-Corporations and Trusts mix?

Certain types of trusts can own shares in an S-Corporation. An Electing Small Business Trust (ESBT) is one such trust that is specifically permitted by the IRS to hold shares in an S-Corporation.

An ESBT is a type of trust that meets certain criteria outlined by the IRS, allowing it to be a shareholder in an S-Corporation. ESBTs must meet specific requirements, including:

1. Qualifying Beneficiaries: An ESBT can only have certain individuals as beneficiaries, such as individuals who are U.S. citizens or residents, estates of deceased individuals, and certain charitable organizations.
2. Taxation: Income earned by the S-Corporation that is attributable to the ESBT is taxed at the trust level rather than at the beneficiary level.
3. Limitations: There are limitations on the types of trusts that can qualify as ESBTs, and not all trusts are eligible.

In general, a revocable trust can’t own shares in an S-Corporation directly. The IRS does not consider a revocable trust as an eligible shareholder for an S-Corporation.

A revocable trust is often set up for estate planning purposes, and during the grantor’s lifetime, the trust is usually treated as an extension of the grantor for tax purposes. Since the trust can be altered, amended, or revoked by the grantor, the IRS typically doesn’t recognize it as an independent entity eligible to hold shares in an S-Corporation.

However, if the revocable trust becomes irrevocable due to the grantor’s death or other specified conditions, it might meet the requirements to qualify as an Electing Small Business Trust (ESBT). An irrevocable trust, if structured appropriately and meeting all ESBT criteria set by the IRS, might be eligible to own shares in an S-Corporation.

To qualify as an ESBT, the trust must meet several requirements:

1. Qualifying Beneficiaries: An ESBT can have only certain individuals or entities as beneficiaries. These include individuals who are U.S. citizens or residents, estates of deceased individuals, certain charitable organizations, or certain qualifying trusts.
2. Limit on the Number of Potential Current Beneficiaries: An ESBT cannot have more than 100 potential current beneficiaries at any time during the tax year.
3. Irrevocable Election: The trust must make an irrevocable election to be treated as an ESBT for tax purposes. This election is made by filing Form 1041-A, which notifies the IRS of the trust’s intention to be treated as an ESBT.
4. Separate Accounting: The trust must maintain separate accounting for the portion of the trust assets and income that relate to the S-Corporation stock held by the trust. This is essential for taxation purposes, ensuring that only the income attributable to the S-Corporation stock is subject to income tax.
5. Taxation of Income: Income from the S-Corporation shares held by the trust is taxed at the trust level rather than passing through to the beneficiaries. However, certain distributions from the trust might be taxable to the beneficiaries.
6. Compliance: The trust must comply with all the rules and regulations set by the IRS for ESBTs, including timely filing of required forms and maintaining eligibility criteria throughout the tax year.

Roberts Law, PLLC is happy to assist business owners that are getting started, getting in compliance, or growing. Contact us  to discuss your needs and how we can help your business run smoothly.

Author: Kelly Roberts

Kelly Roberts is a business and bankruptcy attorney at Roberts Law, PLLC with over a decade of experience assisting business and business owners to navigate contracts, partnership structures, negotiations, and dispute resolution. Kelly earned her Juris Doctorate from the University of Miami School of Law.

Disclaimer: The information in this blog post (“post”) is provided for general informational purposes only and may not reflect the current law in your jurisdiction or the jurisdiction applicable to your issue/matter. No information contained in this post should be construed as legal advice from Roberts Law, PLLC or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.