As far as governance goes, an S Corporation operates the exact same way as a C Corporation (follows state corporate law and federal securities law). The key distinction between the S and the C is how the IRS treats the taxation of the different entities. So, S Corporations are corporations that qualify and have elected to be taxed similar to a partnership. However, there are some corporate tax rules that still apply regarding formation, liquidation, and redemption. In other words, the taxation of S Corporations consists of a blend of corporate and partnership taxation principles (with an emphasis on the partnership aspect).
Qualifications
To elect to file under subchapter S, thte corporation must:
- Be a domestic eligible corporation (within the United States)
- Only issue common stock (no preferred). However, these shares could contain different voting rights.
- Consist of 100 or fewer shareholders. Shares owned by multiple family members count towards only one of the total.
- Shareholders can only consist of individuals, estates, & revocable trusts (no other entities such as LLCs, Corporations, or Partnerships).
- Shareholders cannot be nonresident aliens. In other words, the shareholder must be a US citizen or a US resident.
- Limit the scope of services offered by the business (no financial services such as banking or insurance).
Election
To elect to be an S Corporation, the corporation must file IRS Form 2553 and receive unanimous shareholder consent. If the election is made, it becomes effective on the first day of the following year (unless the election is made by March 15th of a taxable calendar year, then it is retroactive to the beginning of the year).
Termination of the Election
There are several ways to lose the S Corporation status. First, the shareholders can voluntarily revoke the election (a majority of shares). Second, the entity no longer qualifies as an S Corporation. Third, the corporation generates excessive passive income (more than 25% of gross receipts) for three consecutive years. However, this third method of termination only applies if the S Corporation has Earnings and Profits.
If termination occurs, then the corporation must wait for 5-years before being permitted to reapply.
Computating Taxation of S Corporations
S Corporations need to file form 1120S and taxed similar to partnerships except S corporations are required to recognize gains (but not losses) and there are no special allocations or social security tax on income allocations.
Allocation of Income and Loss
Each shareholder is going to be allocated a portion of the income or loss of the S Corporation. The total allocated to the shareholders may change if the shareholder’s shares adjust during the taxable year.
Shareholder Basis
The initial basis depends on whether the stock was obtained by contribution, purchase, gift, or other method. Basis can increase by contributing more (property basis rather than FMV of property is added) and by being allocated a share of the income. However, basis reduces when there are distribtuions from AAA (accumulated adjustments accounts) and allocated shares of losses or deductions. The key difference between basis adjustments for a S Corporation rather than a partnership is that a partnership adjusts basis for liability adjustments (S Corporations do not need to do this because the corporations structure provides liability protection).
Distibutions
The value of the distribution is equal to cash and the fair market value of any property (minus any debt encumbering the property).
If there is no remaining E&P from before the S Corporation existed, then the distributions are not taxable as long as the distributions do not exceed the stock basis (any excess is taxed as a gain).
However, if there is remaining E&P the tax considerations change. The S Corporation equivelant of E&P is the Accumulated Adjustments Account (AAA) and Other Adjustments Account (OAA). AAA is different than E&P because the AAA is taxed to the shareholders rather than the corporation. So, when there is a distribution, the total is first pulled from AAA until depleted. Anything left over is pulled out of E&P but then taxed to the shareholders. Once the stock basis is 0, then the excess is treated as a gain.
AAA is represented by the cumulative undistributed income after the S-election has been made. The total increases by income and reduces by losses and distribtuions (similar to E&P).
Losses
Losses can only be allocated to shareholders if they have basis in the corporation. However, if the loss exceeds the stock basis, the excess can be applied to the basis of indebtedness (shareholder’s also a bondholder) if the shareholder has also loaned to the corporation. If the loss further exceeds the debt basis, then nothing else is deductable by the shareholder until the basis increases again.
Taxing the S Corporation Directly
There are times when the S Corporation is directly taxed. Any preexisting gain from a prior C corporation if the gain is recognized within the first 5 years after the S-election. Any recognized gain is limited to taxable income. Prior C Corporation net operating losses (NOL) can offset the gain.
