Should I be an S corporation? What is an S corporation? Business owners may ask their business attorney these questions as they are forming their business or when considering their entity structure and the taxation of their business. The article below, drafted by a Denver business attorney discusses an S corporation as an entity choice for operating a business.
A corporation that meets the requirements of Internal Revenue Code section 1361 may make the election to be taxed as an S corporation. The requirements are: the corporation must have no more than 100 shareholders; all shareholders must be individuals (other than nonresident aliens), estates, qualified trusts, electing small business trusts or certain tax exempt organizations; the corporation may only have one class of stock; the corporation may not be a financial institution, insurance company, possessions corporation or DISC.
An S corporation may also own 80% or more of the stock in a C corporation, and the liquidation of a C corporation into an S corporation is governed by the rules of Subchapter C, specifically Internal Revenue Code Sections, 332 and 337.
An S corporation that has a wholly owned subsidiary can make an election to treat the subsidiary as a qualified subchapter S subsidiary. Under such circumstances the subsidiaries assets, liabilities and items of income, deduction and credit are treated as those of the parent S corporation. Thus, the separate existence and status of the subsidiary is ignored for tax purposes. When such election is made, the subsidiary is deemed to have liquidated in a tax free liquidation under Internal Revenue Code sections 332 and 337 immediately before the election was effective. The built in gains rule under Internal Revenue Code 1374 will apply
Certain types of trusts can also own stock in an S corporation. To qualify, the trust is treated as owned by an individual who is a citizen of the United States; the trust is a trust with respect to stock transferred pursuant to a will; the trust was created primarily to exercise the voting power of stock transferred to it; or an electing small business trust. An electing small business trust is a trust that has no beneficiary other than an individual, an estate, or certain charitable organizations.
The make the S corporation election, the corporation will likely file Form 2553. All shareholders must consent to the S election and the election is filed with the Internal Revenue Service on or before the 15th day of the third month of the Corporation’s taxable year. Taxpayer’s may be allowed relief for certain late filings of the election under certain revenue procedures.
A new corporation that makes the S election is not subject to tax at the entity level. An S corporation is a pass through entity where by the profits, losses, credits and deductions are passed through to the individual shareholders and claimed on their 1040 Individual Income Tax Returns. The amounts passed through to shareholders are passed through pro rata per the shareholders ownership interest. Because an S corporation can only have one class of stock, an S corporation does not have the flexibility of an LLC or partnership in allocating income or losses. Losses from an S corporation may be deducted only to the extent of the shareholder’s basis in their stock and any indebtedness of the corporation to the shareholder.
A shareholder’s basis in their stock will reflect their capital contributions to the corporation and will be increased by their pro rata share of corporate income and decreased by their pro rata share of losses and distributions to the shareholder. The basis cannot decrease below zero. Losses or deductions that exceed a shareholder’s basis can be applied to reduce the basis in indebtedness of the S corporation to the shareholder under Internal Revenue Code section 1367(b)(2). A shareholder’s basis is not increased by corporate level obligations to third parties. When the distributions are made to a shareholder that do not exceed the shareholder’s basis in the stock, are not taxed to the shareholder under Internal Revenue Code Section 1368(b).
It is important to know that certain states do not recognize S corporations and thus will tax the entity as a C corporation. You can speak with a Denver business attorney at The McGuire Law Firm to discuss your business law questions and issues. A Denver business attorney can assist you with forming and structuring your business, the tax implications of your business, business operations and the eventual sale, transfer or disposition of business assets or interests.
Schedule your free consultation with a Denver business attorney at The McGuire Law Firm! Offices in Denver and Golden Colorado.