For many in business thinking about incorporating, electing S corporation status may be the way to go. The reason is simple: tax avoidance.
By choosing to become S corporations, small and medium size businesses are able to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. In doing so, the entities themselves circumvent paying corporate and payroll taxes.
No doubt about it, for certain domestic corporations having no more than 100 shareholders or one class of stock, S election can be quite beneficial.
But What Is an S Corporation?
An S corporation is not unlike a C corporation, but for its tax status. Both business types are for-profit companies, incorporated under and governed by state corporation laws, and each offer similar liability protections. Likewise, S and C corporations must adhere to the same internal practices and formalities (e.g., maintain boards of directors, be governed by written corporate bylaws, conduct regular shareholders’ meetings, etc.). Of note, an LLC taxed as a corporation can also make an S election. To become an S corporation, a business must first be organized as a C corporation or an LLC (taxed as a corporation), at which point Form 2553 is filed with the IRS electing S corporation status.
The big difference between an S corporation and C corporation is simply this: profits from a C corporation are taxed to the organization when earned, then taxed to the shareholders when distributed as dividends, thus creating a double tax. For its part, an S corporation is authorized to pass income directly to shareholders without being taxed at the corporate level. As such, an S corporation is known as a “pass-through entity,” (like an LLC). More specifically, an S corporation’s income, losses, deductions, and credits flow through to its shareholders, who report these items on their individual tax returns and pay all taxes (including payroll taxes).
S corporations, which get their name from Subchapter S of the Internal Revenue Code, are only available to businesses meeting the following eligibility requirements:
- Must be taxed as a domestic corporation
- Shareholders are individuals, certain trusts, and estates (but not partnerships, corporations or non-U.S. citizens or non-U.S. residents)
- Can have no more than 100 shareholders
- Cannot be an ineligible entity (e.g., certain financial institutions, insurance companies, and domestic international sales corporations
- Has only one class of stock
It is important to understand that these requirements must be maintained at all times—the failure to do so could result in a company losing its S corporation status.
Another Benefit of S Corporation Election
One of the great benefits of forming S corporations—and a prime reason for their popularity—is that shareholders can be employees too. From a tax perspective, this allows an owner of an S corporation to avoid paying payroll taxes on all business income, and instead limit payroll taxes to shareholder-employee salaries.
The IRS requires that any shareholder-employee of an S corporation receive reasonable compensation for services performed, which compensation is to be paid through the company’s payroll system. While this salary is subject to payroll taxes, additional distributions made to shareholder-employees beyond their reasonable compensation are not. In practice, this means that owners of S corporations can potentially reduce their overall tax liability by avoiding payroll tax on income paid to shareholder-employees by limiting salaries in favor of distributions.
This is not without risk. The IRS scrutinizes the compensation paid to shareholder-employees of S corporations to ensure it is reasonable. If salaries are deemed unreasonably low, the IRS may reclassify distributions—at least a portion of them—as wages subject to payroll taxes. Consequently, it is important for owners of S corporations to work with experienced tax professionals to ensure that compensation is structured properly and meets the IRS’s requirements.
S Corporation Pitfalls
The downside of S election oftentimes presents itself where acquisitions of S corporations are contemplated. In the M&A context, a primary risk of acquiring the equity of an S corporation (beyond the general S corporation ownership restrictions) is that the transaction could result in the acquisition of a target corporation that previously failed to maintain its S corporation eligibility requirements (for example, if the target S corporation was previously owned by an ineligible holding company or was deemed to have more than one class of stock). This could serve to terminate the target’s S corporation status and the tax advantages that come along with it. In such a circumstance, the acquired entity defaults to C corporation treatment for tax purposes.
For a buyer of equity in an S corporation, the financial implications of the company losing S election status can be monumental. To the extent the entity is retroactively taxed as a corporation that has not filed corporate tax returns or paid corporate taxes for a period of time, these outstanding tax obligations become the buyer’s responsibility. This can be rather material, especially where the inadvertent termination event happened well in the past.
While the buyer in such a transaction would likely have rights to recover damages by asserting indemnity claims, the time and expense of pursuing them would not be ideal and should be avoided by way of proper pre-closing due diligence, during which time buyers should consult with their tax and legal professionals for advice. This counsel could possibly include consideration of Internal Revenue Code § 338(h)(10) election, a useful tool for buyers to sidestep the ownership restrictions under the S corporation eligibility requirements by treating an acquisition as an asset sale for tax purposes, as opposed to the sale of stock. A § 338(h)(10) election also allows the buyer to increase the tax basis of the assets acquired to fair market value (known as a step-up tax basis), which can result in significant tax savings to the buyer (such as accelerating greater depreciation and reducing taxable income).
Bear in mind, a § 338(h)(10) election does not cleanse a transaction where an inadvertent termination of S corporation status has previously occurred prior to closing. A transaction proceeding under § 338(h)(10) will lose associated tax benefits if it is discovered that the target company previously lost S corporation status. When confronted with this risk, parties can consummate a common restructuring of the S corporation on a pre-transaction basis using an F Reorganization under Internal Revenue Code § 368(a)(1)(F)—this is a type of qualifying tax-free reorganization that changes the identity or form of a corporation and provides certain tax benefits, including a step-up in tax basis of a target’s assets and tax deferral on an equity rollover.
The Devil Is in the Details
Of course, as is the case in all things tax- and law-related, navigating the pros and cons of S corporation election involves a lot of fine print. Without question, matters involving QSubs (Qualified Subchapter S Subsidiaries), the process to effectuate F reorganizations, and the like require an in-depth understanding of the Internal Revenue Code and deal structures. Suffice to say that S corporation election may be right for any number of small businesses across industries, so long as owners are aware of the associated limitations on attracting capital in an S corporation structure, plus the risks and strategies necessary to manage the acquisition of these types of entities, both from the buy- and sell-side.
As always, the corporate professionals at Michelman & Robinson, LLP are available for guidance.
This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.