By Neil Salyards, Esq.
Most small business owners will consider structuring their corporation or LLC as an S-Corp at some point. This is likely because they were informed that they can avoid double taxation – i.e. being taxed on corporate income and again on personal income, by passing corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes, or to take advantage of the ability to pay its shareholders or members “reasonable compensation” and avoid paying self-employment tax on all tax that flows through. While these options are certainly attractive and advantageous in many business structures, one must consider the requirements of making the S-Corp election to determine if his or her business is eligible, and even if eligible at the time of making the election, whether the intended future growth and direction of the business will be appropriate for maintaining S-Corp status.
To qualify for S-Corp status, the entity must meet the following requirements:
- Be a domestic corporation
Have only allowable shareholders
- May be individuals, certain trusts, and estates, but not partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
I often represent businesses whose S-Corp eligibility hinges on the requirement that the entity have only one class of stock. For IRS purposes, this requirement means, among other things, that the entity cannot have “special allocations”, i.e. non-pro rata allocation of profits and losses. It may seem like a straight forward solution – have one class (common stock for a corporation or units of equal value for an LLC) and allocate profits and losses according to each owner’s percentage of ownership. However, the situation commonly arises in an LLC where the owners desire a deviation from their pro rata allocation of profits and losses. These special allocations are common in LLC Operating Agreements, and are otherwise universally accepted.
However, special allocations are strictly prohibited in S-Corps because the IRS considers it the creation of separate classes of stock. Most importantly, the governing documents of an S-Corp cannot provide for special allocations, and if they do, the entity is at risk of losing its S-Corp status. For example, an Operating Agreement of an LLC that elects to be taxed as an S-Corp cannot allow for non-pro rata distributions.
If you own and operate an entity that made its S-Corp election after its governing documents were drafted, it is advisable to have an attorney review those documents to ensure they do not provide for special allocations in order to prevent a determination by the IRS that your business has been operating with more than one class of stock – resulting in a loss of its S-Corp status.
For more information on this topic and other business formation questions, please contact Neil A. Salyards, Esq. at firstname.lastname@example.org.