S Corporations offer the benefit of passing income through to shareholders for taxation instead of being double taxed, once at the entity level, and once as a dividend when profits are distributed. To maintain S Corporation status, there are several criteria businesses must follow to avoid termination of the S-election. Some of the commonly overlooked items for maintaining an S-election include:

  • No more than one class of stock; however voting and nonvoting stock is allowed
  • No more than 100 shareholders
  • Eligible shareholders of an S-Corporation are:
    • Individuals
    • Testamentary trusts and estates (but only allowed for 2 years)
    • Qualified Subchapter S Trusts (QSST) – Must have 1 beneficiary & all income must be distributed
    • Electing Small Business Trust (ESBT) – Taxed at highest individual rate
    • Partnerships, LLCs, and C Corporations are not eligible shareholders
  • Disproportionate distributions – S-Corporations must make distributions on a pro-rata basis based on ownership percentages – the exception may be a change of ownership
  • Debt cannot appear to be equity or convertible (terms cannot be contingent on profits
    • Stock should not be pledged to ineligible shareholders
  • Former C Corporations with undistributed income have limited passive income they can earn
    • After 3 years of excess (>25%) passive income the election will terminate

With an S-election, profits avoid the self-employment taxes that would be incurred by a partnership. Due to abuse in this area, owners should ensure they are paid reasonable wages for the services they are providing. While wage variances generally do not terminate the S-election, it could cause additional tax if audited by the IRS.

Additionally, when there is an ownership change, the income must be split between the periods of change. S Corporation ownership changes require the proration method, which allocates the entities income and loss on a per-share, per-day basis unless the shareholders elect the “cut-off method.” The Cut-off Method is a closing of the books on a specific day, effectively creating two separate periods.

While the above items can be easily overlooked, failing to comply with any of these criteria may significantly impact your business on many levels, including loss of your S-election.

Contact us if you would like an analysis of your current business structure to make sure your S-election is safe and being used effectively.

About the Authors

James B. Skakun

CPA
Manager, Taxation Services

Michael Hydell

CPA, MTax
Senior Manager, Taxation Services

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