An S Corporation is a corporation created under state law as to its entity form, but which elects to be taxed under Subchapter S of the IRS Code. In order to have the S corporation tax status, the entity must file an election with the IRS.
As to entity structure, it is a corporation which has shareholder, directors, officers, and employees. It has Articles of Incorporation and Bylaws. It is subject to statutes and case law related to corporations generally. As to tax treatment, the profits and losses pass-through the entity and are taxed at the shareholder level rather than the corporate level. In some states with income taxes, an S corporation is treated as a pass-through entity, in others, it is treated by the state as a C corporation. Other than the way it is taxed, an S corporation is indistinguishable from a C corporation.
Ownership
The owners of the S corporation are the shareholders. The shareholders should be issued Certificates of Stock stating the number of shares each shareholder owns, and a stock ledger should be maintained by the corporation regarding the stock. Certificates of Stock should be treated like any other document evidencing title and kept in a safe place by the owner. The shares of an S corporation have specific restrictions if the S election is to be maintained. This includes that S corporation may only have one class of shares meaning they must all be the same and cannot be divided into different types of shares with different voting rights, priorities for distributions, or other distinguishing characteristics. Only natural persons, certain trusts, and estates can own shares of an S corporation, no owner can be a non-resident alien, a partnership, or corporation, and the number of shareholders is limited to 100.
Liability
Shareholders have limited liability for the acts and liabilities of the corporation the same as a C corporation. The assets of the corporation are available to creditors, but the personal assets of shareholders are protected.
The liability shield can be pierced in certain situations under statute or when the separate existence of the corporation is not respected. Piercing the corporate veil is an unusual remedy and generally only applied in serious situations of undercapitalization, comingling of funds, fraud, and the like.
Notably, as a practical matter, a closely held S corporation’s shareholders may be required by third party service providers, lenders, or vendors to guaranty accounts due to the lack of credit of the corporation. In such situations, the shareholders who guaranty the accounts are personally liable under those contracts, even if they have limited liability for the corporation.
Control
The business operations of an S corporation, like a c corporation, are managed by its board of directors. The directors are elected by the shareholders. The shareholders otherwise have minimal rights to control the operations of the corporation. The shareholders generally only have the right under the statutes or governing documents to vote on extraordinary transactions such as merger, dissolution, or a sale of a substantial portion of the corporate assets. In the absence of cumulative voting rights, the majority shareholder generally has control of the corporation, and minority shareholders have limited options for effecting the management of the corporation. Shareholders may enter into Shareholder Agreements which may provide certain rights or responsibilities regarding the voting of shares for directors or other activities. Shareholders do have the right to hold the board of directors responsible for their duties to the shareholders.
It is important to remember in closely held corporations that the role of the shareholder is different from the role of the director. Often, a shareholder is both a shareholder, a director, an officer, and an employee. Many problems can be avoided or resolved, and many opportunities exploited, by maintaining the distinction between these different roles, and respecting the structure of the corporation.
Transferability of Interests
Shares in an S corporation are freely transferrable as with a C corporation. The shares are treated as property and the death, incapacity, or bankruptcy of a shareholder does not dissolve the corporation. However, in order to maintain S corporation tax election, the restriction on who can be a shareholder of S corporation shares will often restrict the transferability of the shares or cause a potentially problematic change of the tax status including additional tax liabilities.
Shareholders can enter into Shareholder Agreements and/or Buy Sell Agreements which restrict or require the transfer of shares in different situations as a means of controlling the ownership of the corporation. Shareholders may want to make sure that new shareholders have the skills and abilities necessary for the role, and they may want to connect the role of shareholder to the role of an officer or employee.
Shares are subject to security laws which may also limit or restrict the transfer of shares.
Organizational and Maintenance Costs
A corporation is more expensive generally than partnership, and more like an LLC, but also has some aspects which make it more potentially more expensive than an LLC. The corporation must file Articles of Incorporation with the state, and register in states that it does business. It must also file annual reports to the state, and is often subject to tax returns, or informational returns for an S corporation, to both the federal and state authorities.
Corporations generally require good bookkeeping for the corporation, and the corporation has specific forms it should maintain as a result of being a corporate form. Specifically, a corporation has defined roles for shareholders, directors, officers and employees which should be documented. Those roles, and their distinctions, also should be documented in the form of at least annual meetings regarding shareholder decisions, board of director actions and decisions, and so on. In part, this is to comply with statutory and tax requirements.
Taxes
An S corporation is taxes similarly to a partnership. The S corporation files an informational return, and the profits and losses are passed through to the shareholders on their personal returns. Losses that are passed on are subject to the passive loss limitation and at risk rules of the IRS code.
LLCs have the advantage of being taxed more like a partnership (if that is the tax election) in that:
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liabilities of the LLC can be counted in determining the basis of the members in their ownership interests;
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special allocations of income and losses can be made allowing disproportionate distributions; and,
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the tax basis of an LLC can be changed in certain circumstances involving the death of the member or transfer of a member’s interest.
Notably, if the LLC elects to be taxed as an S corporation, these advantages do not exist.
On the other hand, S corporation election can provide advantages from an employment perspective. In short, shareholders who are also employees can have their compensation divided between salary and distributions. Salary is subject to self-employment taxes while distributions are not. In addition, health insurance premiums for shareholder employees can be paid by the corporation and are not counted as salary. The corporation deducts the payment, and the shareholder has to report the premiums as income, but the portion of compensation paid as premiums are not subject to self-employment taxes. S corporations also have the ability to take deductions on certain business expenses of the corporation that might not be available to partnerships or sole proprietors when doing their deductions on their personal returns.
The conversation of an S corporation to another entity type is allowed, but can have detrimental tax consequences.
The advantages of an S corporation include the following:
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All shareholders enjoy limited liability;
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Stock is freely transferrable subject to limitations for shareholders of an S corporation or agreements;
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S corporations can have perpetual existence and survive the death, incapacity, or bankruptcy of shareholders;
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An S corporation has centralized management by the board of directors and extensive case law and statutes providing more predictability and stability;
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Profits are subject to only one level of tax;
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Losses are available to shareholders;
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Sale and redemption of stock generally result in capital gains, not ordinary income;
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S corporations can issue stock options to employees; and,
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S corporation income to shareholders that is not compensation for services is not subject to employment taxes.
The disadvantages of an S corporation include the following:
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S corporation shares are subject to restrictions and limitations including the number and type of shareholders;
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Corporate formalities are required for the organization and operation of an S corporation;
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Qualifications and registration are required for out-of-state business;
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Regular reporting to governmental entities is required;
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Stock transfers are subject to securities law regulation; and,
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Distribution of property by the S corporation to shareholders is generally a taxable event for income tax purposes for the corporation such that it can be expensive from a tax standpoint, and it is generally inadvisable to try to change the entity type or tax election.
A good sales process is a perpetual cycle. You have a product, you market it, you sell the product to the right people, and then you have cash flow to grow, survive, and sell more product. Sometimes, we get into the habit of treating the sale as if it is the end, rather than a recurring part of the process. And, even if we don’t treat the sale as the end, we often treat sales contracts as separate and distinct, stand-alone documents. We may develop a contract for security or risk reasons, like to avoid liabilities or to secure cash flow, but we treat them as otherwise independent of the rest of the success of the sales cycle.
