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The S-Corporation


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Internal Revenue Code:
We have mentioned the Internal Revenue Code (IRC) in passing in previous chapters. However, it is important to understand precisely what it is. The IRC is the informal name for the 26th title of the United States Code, and it represents the rules for all tax law in the U.S. The “Code”, as it is known to tax practitioners, is less of a single text (if fact, it would take about twenty three-inch-wide volumes to contain it all) and more of a living, breathing embodiment of the U.S. system of taxation.

The reason for this characterization is because the Code, as administered by the Internal Revenue Service (IRS), is constantly being updated and amended to deal with the myriad issues that the IRS encounters on a daily basis. Thus, while the Code itself is actually a smaller set of rules, this single set of rules is then supplemented with Code “regulations” and “revenue procedures,” which are issued by the IRS on almost a daily basis. In the end, dealing with the Code in the legal profession is largely the domain of tax experts who make it their job to stay abreast of the latest changes to the Code.

Check the Box:
The “Check the Box” rules, as they have come to be known, are a set of rules in the IRC for business filers. The goal of the rules is to create a simple means via which companies can indicate if they would prefer to be treated as either a partnership (i.e., pass-through) or corporate entity for tax purposes.

The way that the Check the Box rules work is that, by default, a company will be treated as a partnership for tax purposes. If, however, the company would prefer to be treated as a corporation – or a special type of corporation such as an S corporation – then all that company need do is “check” the appropriate box on its tax return.

In large part, the rules work as they were intended to work, and have gone a long way in simplifying the process of a firm identifying its business character. However, the rules have also created many problems and have given rise to a large number of situations where determining the status of a firm’s eligibility for any given “box” can be very difficult.

Introduction to S Corporations

The S corporation, like the professional corporation that we discussed in the previous section, is a hybrid business form that was created with the intention of balancing the benefits and detriments of the corporation and partnership into a single business entity. However, like the PC, the S corporation has seen a large number of it potential users elect either the LLC or LLP business form over the S corporation form. The reason for this is   while the S corp does offer pass-through taxation and limited liability, the requirements that must be met to qualify for S corp status are extremely stringent. 

Businesses that might be S corporations:

  • A small, domestic company operating an importing business
  • A product manufacturer or retailer with a limited product line acting solely in the U.S.

Characteristics

Unlike most of the other business forms that we have discussed, which are largely a product of state business laws, the S corporation is actually a product of the Internal Revenue Code (IRC). When filing its taxes, a firm that fits the IRC’s requirements for an S corp is allowed to elect that form as its business entity of choice. However, as you will see below, those requirements may be difficult for most firms to meet.


Formation
An S corp, in terms of logistics, is probably the easiest business form to produce. In truth, all that is required for a business to elect S corp status is to “Check the Box” on its tax return indicating that it wishes to be treated like an S corp for purposes of taxation. See 26 USCS § 1362.

However, while that may be the only actual step to create the S corp, meeting the eligibility requirements to check that box is not so easily accomplished. Ultimately, the reason why the S corp has never been fully adopted in corporate America is because the IRS has placed a litany of requirements on a firm before it can elect S corp status. The following represents just a sampling of the major requirements placed on an S corp:

  • S corp must be a U.S. domestic corporation
  • Shareholders may only be individuals, estates, or some trusts and the company cannot be a member of a group of corporations
  • The corporation may have only one class of stock
  • There may not be more than 100 shareholders for the firm
  • No shareholder can be a non-resident alien in the U.S.

See 26 USCS § 1362(b).

Given this list, it becomes immediately apparent why the S corp form has limited appeal to businesses. First, it is difficult to create a corporation that meets all of these requirements and still garner the sorts of funding that are required to form a new firm. Moreover, ensuring year after year that the company continues to meet these requirements is also incredibly burdensome. Keep in mind that if any of the above terms is no longer met, then the company may no longer elect S corporation status and will then have to transfer itself either into a full corporation or a partnership.

EXAMPLE: Gwyneth, Yvonne and Kyle are setting up a new company. They feel that they have a real chance of competing successfully in the business of building and selling laptop computers. As previously successful entrepreneurs, each of the three would like to take what losses the new company is sure to generate against his or her own tax returns. Additionally, however, they want to protect their personal fortunes from any sort of liability arising from the firm.

For all of these reasons, the S corp looks like a good choice. However, when reading the requirements for creating an S corp, Yvonne recognizes a problem. If the company’s business plan is to succeed, it is clear that they will need a large infusion of capital, potentially from foreign investors, sometime in the near future. Furthermore, if such capital is not available, she knows that the firm will need to seek money either from a professional venture capital firm or another computer manufacturer who might invest in them for their R&D. For these reasons, she tells the others that the S corp form is not the right choice for them.


Ownership and Operation
Ownership of an S corporation is probably the single largest difficulty in forming the firm. As was discussed above, the IRS has placed many requirements on a firm electing S corp status in terms of who can own the company. First, the company cannot be owned by another company, thus limiting ownership of shares to individuals and certain organizations such as trusts. Second, there are limits on the nature of the owners – in particular their residency status. See 26 USCS § 1361. The reason for this requirement is that the IRS did not want S corps to act as a means for foreign investors to shelter their income from taxation in the U.S. Finally, the   seventy-five-person limit on shareholders is a very important limitation on the ability of the firm to organize a substantial ownership pool.

EXAMPLE: Lyle, a citizen of France, wants to invest in a U.S. company to protect his income from the high French taxes. He selects a U.S. company that is a new S corporation and offers it some of his personal fortune for funding. He hopes that the company will be able not only to avoid French taxes, but also to shelter any income he might have from the company with corresponding losses. However, being well versed in the S corp law, the company’s managers decline his investment as it would make them ineligible for S corp status.


Taxation & Liability
The taxation of an S corp as a pass-through entity, see 26 USCS § 1366, combined with the liability shield offered by corporate status, made the S corp the business form of choice for new companies throughout the 1970s, 1980s and into the 1990s. However, the strict requirements imposed by the IRS, combined with the creation (in state law) of the LLC and LLP, have made these benefits available to companies that are otherwise unable or unwilling to comply with the S corp rules.


Capitalization and Fund Raising
Capitalizing an S corp can be a truly difficult project for a company of any real size or prospect. In particular, the fact that no other company can invest in an S corp severely limits a firm seeking to enter a market in which there exists other corporate investors. Furthermore, the fact that no more than seventy-five individuals may invest in the firm seriously limits the options of the new company to raise capital.

In the modern climate, most companies will require more than seventy-five investors. When one considers the fact that initial funding will come from friends and family, along with providing share ownership to employees and professional investors, the seventy-five person cap is reached quickly.

Furthermore, in any of the high-tech fields that are considered to drive the modern economy, it is almost imperative that new firms have at least one corporate investor as a sign that the technology being pursued by the new firm has merit. Thus, the fact that no corporation can invest in an S corp, is a serious issue when such new technology firms consider incorporation.

EXAMPLE: New Gen Corp, an S corp, has created a breakthrough drug that is set to revolutionize the treatment of male-pattern baldness. Convinced of the huge market potential, New Gen approaches several big drug manufactures to sell them shares in the company in exchange for a large investment with attached rights to special dividends. However, before closing any such deal, New Gen’s attorney hears of management’s goal and tells them not to carry through with the investment until the company is changed from an S corp. His reasoning is that a corporate investor will not be able to invest in an S corp. Furthermore, an S corp can only have one class of stock, which is not possible given that New Gen already has shareholders who will not be offered the dividend that management is offering to the corporate investors.


Liquidity
Like initial capitalization, the S corp provides some serious problems for continued liquidity in the firm. If the seventy-five-person cap, or any of the other shareholder requirements are breached, the firm will lose the ability to elect S corp status and thereby lose the single most important benefit of the form, pass-through taxation. Moreover, any firm electing S corp status will henceforth be obliged to insure that it continues to meet the IRS’s requirements so as to avoid deleterious effects on its own tax return, not to mention those of its investors.

EXAMPLE: True Tech has been operating successfully as an S corp for the past five years. Because of a new expansion plan, True Tech decides to invite two new investors – a company and a wealthy foreign businessman – to invest in the firm. Given that the firm already had seventy-five investors, it is not long after its tax filing that the IRS informs the firm that its filing, which indicated that True Tech is still an S corp, is inaccurate because it has more than seventy-five investors and some of those investors are non-U.S. individuals. As such, the IRS reassess the company’s taxes for the year and gives it a huge tax bill.



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