Business owners are often attracted to the S Corporation as a hybrid between the entity-level tax planning opportunities afforded by C Corporations and the passthrough nature of a partnership, all while affording a business owner the liability protections anticipated from an incorporated entity. However, S Corporations come with a laundry list of eligibility requirements that must be observed lest an unsuspecting business owner inadvertently terminates its S Corporation status. These requirements apply both to state-law corporations that have made S Corporation elections, as well as to state-law LLCs that have elected to be characterized as S Corporations.
The inadvertent termination of S Corporation status can have disastrous tax consequences. For example, in the case of an entity that previously operated as a C Corporation, the termination of S Corporation status would lead to the imposition of entity-level tax dating back to the initial date of termination. In some instances, this can amount to years of unremitted taxes. To make matters worse, most business owners aren’t aware of the events that caused an inadvertent termination until they are called out by competent tax counsel or the IRS (often in the context of M&A diligence, or an audit).
Common pitfalls that can trigger the invalidation and termination of an S Corporation election are as follows:
S Corporations may only maintain one class of stock, with some nuances as reflected in Treas. Reg. 1.1361-1. If the S Corporation issues stock with varying liquidation preferences or dividend preferences, it may be deemed to possess multiple classes of stock, thus endangering its S Corporation status. In some instances, the S Corporation can be deemed to have issued a second class of stock even when no-issuance occurs. Two of the most common “phantom” second-class of stock issuances are:
Shareholder Loans / Related Party Debt: Under certain IRS guidance the issuance of debt in the form of shareholder or related party loans that lack typical indicia and characteristics of a bona fide debt instrument (e.g., low or no stated interest rate, no maturity date, thinly capitalized borrower, etc.) may be classified instead for U.S. federal income tax purposes as an issuance of stock. Accordingly, the debt may be treated as a second class of stock.
Excessive or Unreasonable Compensation of Executives: A similar analysis applies with respect to unreasonably high or “excessive” compensation of executives of an S Corporation, or with respect to preferential or improper distributions of property or cash to a shareholder. Under certain circumstances, the IRS can view “excessive” distributions as being based on an informal underlying equity interest in the S Corporation.
Perhaps the largest pitfall for new business owners is the unintentional creation of a second class of stock caused by the poorly drafted governing documents of an S Corporation. Treas. Reg. Sec. 1.1361-1(l)(2) authorizes the IRS to look to the S Corporations’ governing documents (e.g., the articles of incorporation and bylaws) to determine whether second class of stock issues exist stemming from differing shareholder distribution and liquidation rights. An S Corporation’s operating agreement must allocate income, deductions, or losses among shareholders in a manner consistent with the rules laid out in IRC Sec. 1366, which requires that allocations be strictly proportional to each shareholder’s ownership interest. Often, governing documents and agreements, while aiming to facilitate governance and profit-sharing arrangements, may inadvertently introduce partnership tax concepts such as capital accounts, special allocations, curative allocations, or similar items. These can inadvertently undermine S Corporation’s status by inferring that distributions or liquidations may be made in a fashion inconsistent with the foregoing requirements.
In addition to the headaches an inadvertent S Corporation election termination can cause for a business owner, these second class of stock concerns can also be significant in a deal context, namely to a potential acquirer. As background, once a buyer acquires an S Corporation, the tax liabilities stemming from any historical inadvertent S Corporation election termination would inure to, and be the responsibility of, that buyer. It is accordingly the case that buyers will often perform (through tax counsel or tax consultants) meaningful tax due diligence to uncover any inadvertent terminations prior to acquiring the S Corporation. Once a buyer locates a second class of stock issues, they will typically use them to re-trade for a lower purchase price, or request enhanced indemnification from a seller. There are other mechanisms for a buyer to avoid second-class of stock risks such as specific insurance programs and tax-specific reorganizations, but the costs associated with these are often passed through to the seller. As a result, it is always in a business owners’ best interest to stay vigilant of any second class of stock issues that may arise in the ordinary course of business operations.
Best practices for an S Corporation business owner include:
S Corporations offer substantial tax benefits and liability protection for business owners, but they require strict adherence to complex rules and regulations. The potential pitfalls, including the risk of losing S Corporation status due to second-class of stock issues, underscore the significance of meticulous planning and tax legal compliance. Business owners should proactively manage their S Corporation status and engage tax legal professionals to avert possible adverse outcomes.
The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.
Philadelphia Tax Attorney specializing in Partnership Tax, Corporate Tax, and S Corporations. Jared is an attorney in Obermayer’s Business & Finance Department. He focuses his practice on tax structuring and analysis attendant...
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