Why S Corporations

Why "S" corporations? And how do they compare to other entities

Sorting through various established forms of business entities:  corporations, "S" corporations, partnerships, limited partnerships, limited partnerships, limited liability companies (LLC) and sole proprietorships, series LLCs and limited liability partnerships.  Here is a summary of the kinds of organizations: 

  1. "C" or regular corporations are taxed at the corporate level and again at the shareholder level on distribution of dividends, which are company profits for federal income purposes.  These are incorporated under state for profit business laws.  Corporations provide a strong measure of liability protection for shareholders against company debts and liabilities but not for personally guaranteed debts of the business as required by banks and other creditors.
  2. "S" corporations are mostly taxed only at the shareholder level for federal income tax purposes even when no distributions are made to the shareholders and must qualify under the Internal Revenue Code Sections 1361 and 1362.  
  3. Sole Proprietorships require no formal organization with the state.  A sole proprietorship is essentially an unincorporated business with only one owner.  Each owner has unlimited personal liability for the debts and liabilities of the business.  There is only one level of tax, a federal tax on the owner. 
  4. Partnerships require no formal organization with the state save for limited partnerships.  Limited partnerships must have two or more equity owners.  General partners have unlimited personal liability for debts and liabilities of the business while limited partners do not.  There is only one level of tax on partners.  
  5. Limited Liability Companies are roughly hybrid entities of corporations and partnerships and must be formed by state charter.  LLCs offer a single level of tax AND providing the limited liability protections afforded the equity owners of most kinds of corporations.  Of note is that the LLC can be taxes as a "C" corporation or "S" corporation, sole proprietorship or partnership.  Due to the flexibility in tax and other areas the LLC is usually the default choice.  

Ownership:  A single owner has fewer conflicts--legal, business and personal--especially with family owned enterprises.  And, an individual owner can make changes much easier.  

Nature of Ownership:  If the business entity will be taxed as an "S" corporation and the owners must be US citizens or permanent residents. 

Classes of Equity Ownership:  If the business entity will be taxed as an S corporation there can be only one kind of stock except that differences in voting rights are acceptable.  Otherwise distribution and liquidation rights must be the same for all classes.  

Liability Protections for Owners:  Sole proprietors and general partners are afforded no liability protections.  Shareholders of "C" and "S" corporations and members of LLCs are afforded a strong measure of liability protections.  

Management of the Company. "C" and "S" corporations separate the activities of the business, directors and officers, from the passive holdings of the stockholders.  This is known as centralized management although a shareholder can be both management and an equity owner.  General partners can participate in management of the partnership while limited partners cannot.  LLCs can either be manager membered or member managed as in the case of a general partnership.  Management can be a major issue for a closely held family business even where the passive owners have little if any legal records due to their status as limited partners.  

Transferability of Equity Interests.  "C" and "S" corporation stock and limited partnership interests are generally transferable whereas general partnership interests can only be transferred with the approval of the other partners.  Transfers of LLC membership interests are generally limited under the operating agreement or by state law.  Entities can change classifications from time to time.  According to the IRS, "there is a five year waiting period before an election may again be made again, unless waived by the IRS due to a substantial change in ownership--see Treas. Reg. 301.7701-3(c)(1)(iv". 

Continuity of Life.   To the extent that a business can be operated on the death, disability, withdrawal, sale of interest or inactivity of the principal, it might be important for the entity to continue indefinitely or for a period of years to maintain goodwill and going concern value for the remaining owners and successors in interest.  A partnership or sole proprietorship can be terminated upon those events; a "C or "S" corporation or LLC can either operate indefinitely or for a period of years, in a term certain.  

Choice of Law.  Under US Supreme Court precedent and case law of many states, internal governance are controlled by the laws of the state of organization and incorporation.  In determining the choice of entity it is best to consider which state's laws would be most suitable.  

Who Should Use S Corporations? 

This question often arises whether a given company should elect "S" status as compared to whether it can elect S status.  Generally, if the company is to have profits, S corporation status can be a wonderful way of allocating profits among the shareholders.  Conversely, where flow through losses are likely or even desirable, partnership status is much attractive.  S corporations may then be favored for professionals, franchises, niche or boutique firms and other companies likely to produce profits while one might choose  LLC for real estate, restaurants and other ventures.  C corporation status is used for those companies too large for S corporation elections or where flow through taxation is nsot necessarily a desirable trait.  

Pass Through Treatment of S Corporations

A key advantage of S corporations over C corporations is the avoidance of two levels of tax, the first at the company level and the second at the shareholder level upon payment of dividends commonly known as the "double tax".  Company profit and losses pass through to shareholders in a S corporation but not so in a C corporation.  

If the company experiences a loss Section 1366(d) and Treas. Reg. 11366-2 limit the shareholder's loss to the tax basis in the company's stock and any debt owed by the company to the shareholder.  

Liquidation of S Corporation 

The purchaser of a target company will want to acquire the assets of the company and may have concerns that there may be hidden or unknown liabilities or poorly performing assets which will be in the acquired company thus diminishing the value.  That is why the acquirer purchases the assets of the company.  In many acquisition cases the purchased company will liquidate and distribute the proceeds from the sale of assets to the equity owners after debts and taxes have been paid.  

If the purchased company is an S corporation the sale of its assets will produce gain or loss at the shareholder level.  The basis of the stock in the S corporation will increase and and be considered a gain, or if there is a loss from sale of corporate assets, the loss will decrease basis in the stock.  

Compensation Strategies for Owner Employee 

The advantage of S corporation income is avoiding the double tax of C corporation status.  The C corporation can accumulate profits for subsequent investment without accumulated earnings taxes under Section 531 of the Internal Revenue Code.  It is recommended that the salary for the owner be reasonable and that compensation be set forth in an employment agreement to avoid or reduct IRS contests.  It is also good practice provide the occasional bonus where the company has prospered and as allowed by an employment agreement or special resolution to the board.  Bonuses are subject to ordinary employment taxes.  The balance of profits can be taken as a dividend.  Be careful that other shareholders receive a pro-rata portion of dividends so that the IRS does not believe that the company has more than one class of stock. 

However, one wise saying in this area is "don't let the tax tail wage the business dog".  Not all business entity decisions can be made with tax considerations first. 

If you would like to speak about the structure of your entity(s) please call The Law Offices of Gayla K. Austin at 307.200.1914.