Advantages of an S Corporation

An S corporation offers several key advantages for small and closely held businesses. One of the most notable is pass-through taxation, which allows income, deductions, and credits to flow through to the shareholders’ personal tax returns, avoiding the double taxation faced by traditional C corporations.

Other key benefits include:
– Limited Liability Protection – Shareholders’ personal assets are generally shielded from business liabilities.
– Tax Efficiency – Shareholders who work for the company can receive both a reasonable salary and distributions, potentially reducing self-employment taxes.

– Pass-Through Entity (PTE) election allows certain business entities—like partnerships, S corporations, and LLCs taxed as partnerships—to choose to pay state income tax at the entity level rather than passing the tax obligation through to individual owners. This election serves as a workaround to the federal $10,000 cap on state and local tax (SALT) deductions introduced by the Tax Cuts and Jobs Act of 2017.

These benefits make the S corporation structure especially attractive for businesses seeking tax efficiency and legal protection.

S Corporation Basics

To qualify as an S corporation under IRC §1361(b), a business must first elect to be treated as an S corporation. This election must be made by all shareholders and submitted within the appropriate time frame (generally within 2 months and 15 days after the beginning of the tax year the election is to take effect). Once elected, a business must:

– Be a domestic corporation.
– Have only allowable shareholders, including individuals, certain trusts, and estates. Partnerships, corporations, and nonresident aliens are generally not permitted.
– Have no more than 100 shareholders.
– Have only one class of stock, meaning all shares confer identical rights to distribution and liquidation proceeds.
– Not be an ineligible corporation, such as certain financial institutions, insurance companies, or domestic international sales corporations.
These criteria must be continuously met to maintain S corporation status.

Involuntary Termination of S Election

An S corporation’s election can be terminated involuntarily if it ceases to meet the above qualifications. Common causes include:

– Exceeding Shareholder Limits: Having more than 100 shareholders at any time.
– Ineligible Shareholders: Issuing stock to a corporation, partnership, or nonresident alien.
– Second Class of Stock: Creating a second class of stock, intentionally or inadvertently, such as through disproportionate distributions or certain shareholder agreements.
– Passive Investment Income: For S corporations with accumulated earnings and profits (AE&P) from prior C corporation years, having more than 25% of gross receipts from passive investment income for three consecutive years can terminate the election.
– Improper Trust Elections: Failing to make timely elections for qualified Subchapter S trusts (QSSTs) or electing small business trusts (ESBTs) holding S corporation stock.
– Change in Corporate Structure: Becoming an ineligible corporation, such as by converting to a foreign entity.

Relief for Inadvertent Terminations

If an S corporation’s election is terminated due to an inadvertent error, the IRS may grant relief under IRC §1362(f), allowing the corporation to retain its S status retroactively. To qualify, the corporation must:

– Have made a valid S election that was terminated inadvertently.
– Take corrective action within a reasonable period after discovering the issue.
– Demonstrate that the termination was not due to willful neglect.
– Agree to make any adjustments required by the IRS.
The corporation must submit a request detailing the circumstances and corrective measures taken. The IRS will evaluate the request and determine whether to grant relief.

Consequences of Termination

If the S election is terminated and not remedied, the corporation becomes a C corporation effective on the termination date. This change subjects the corporation to double taxation: once at the corporate level and again at the shareholder level upon distribution of dividends. Additionally, the corporation generally cannot re-elect S status for five years without IRS consent.

Best Practices to Maintain S Status

– Monitor Shareholder Eligibility: Ensure all shareholders remain eligible and that any transfers of stock comply with S corporation requirements.
– Review Agreements: Carefully draft and review shareholder agreements to prevent provisions that could create a second class of stock.
– Track Income Sources: Monitor the composition of income to avoid exceeding passive income limits, especially if the corporation has AE&P.
– Timely Elections for Trusts: Ensure that any trusts holding S corporation stock make the necessary elections promptly.
Maintaining S corporation status requires oversight and adherence to IRS regulations. Understanding the rules and implementing best practices can help prevent inadvertent terminations and preserve the tax benefits associated with S corporations.