Often, a small business or start-up will utilize an S corporation election for their business. An S corporation is a corporation formed under a particular State’s incorporation laws (or an organization that has elected to be treated as a corporation for US income tax purposes). The corporation must be eligible to elect S corporation status and its shareholders must consent in writing on Form 2553 to have the corporation elect S corporation status. The Form 2553 must be filed with the Internal Revenue Service (IRS) on or before the 15th day of the 3rd month of the corporation’s tax year in order for the election to be effective as of the beginning of that tax year. If the corporation is on a calendar tax year, the Form 2553 must be filed on or before March 15th in order for the election to be effective for that tax year.
In order to elect S corporation status, a corporation must be a so-called “small business corporation” as specially defined. This means the corporation must satisfy the following major requirements. More detail can be found in the statute itself :
1) It must not have more than 100 shareholders (for this purpose, a husband and wife are counted as a single shareholder; in addition “members of a family” and their estates are treated as a single shareholder).
2) It must be a “domestic” corporation – that is, a corporation organized under the laws of any US State or US territory.
3) Shareholders may only be individuals, estates or certain trusts – partnerships and corporations cannot be shareholders.
4) All shareholders must either be US citizens or US “residents” under the income tax laws (e.g., a green card holder or an individual meeting the so-called “substantial presence” test)
5) The corporation may have only one class of stock.
Taxation of S Corporations
One of the major benefits of making an S corporation election is the “flow through” tax treatment available to the shareholders. Unlike a regular (so-called “C” corporation), making an S election means the income earned by the corporation will not be taxed at the corporate level. All of the income of the S corporation “flows through” to its shareholders and is taxed to them at the shareholder level on their individual income tax returns even if the shareholders have not received any distributions from the S corporation. The general principle is that all items of the S corporation’s income, deductions, gains and losses are allocated among, and passed through to its shareholders in accordance with each shareholder’s respective ownership interest in the corporation. In contrast, a C corporation is taxed on its income first, at the corporate level. Later on, when the C corporation makes a distribution of its after-tax profits to its shareholders, the shareholders are taxed on the dividend received which must be reported on their individual US income tax returns. Thus, the S election serves as a mechanism to avoid “double taxation” (i.e., taxation once at the corporate level and again at the shareholder level).
In addition to filing an annual information return with the IRS using Form 1120S, the S corporation must provide each of its shareholders with a Schedule K-1. This Schedule K-1 permits the individual shareholder to understand his or her share of the items of the S corporation’s income, deduction, gain and loss, based on the shareholder’s ownership interest in the corporation and is needed by the shareholder to properly complete his own US income tax return.
Nonresident Aliens Will Threaten S Corporation Status
A corporation’s tax status as an S corporation can be terminated either voluntarily (shareholders agree to revoke it) or involuntarily. In the case of a voluntary revocation of an S election, shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made must consent to the revocation. An involuntary termination can occur if the corporation ceases to meet the requirements that are imposed for making the S corporation election in the first place (i.e., it fails to continue to meet the definition of a “small business corporation”). For example, an involuntary termination could occur if the corporation suddenly had more than 100 shareholders, or, if it took on a shareholder that was other than an individual, estate, or permitted trust, or if it had a shareholder who was a nonresident alien (NRA).
As a general matter, if the S election terminates because of a specific event that causes the corporation to fail to meet the definition of a “small business corporation”, the termination is effective as of the date on which that event occurs. For example, if a resident alien shareholder of the S corporation had his green card rescinded and was not otherwise a US “resident”, the S election would terminate on the same day as rescission of the green card. Having a foreign shareholder can be risky for the S corporation and its other shareholders since they do not have control over the individual’s maintenance of his US “resident” status.
Watch Out for Community Property Laws
Just how unpredictable the matter can become is illustrated by the case of Ward v. U.S., 661 F.2d 226 (Ct. Cl. 1981). I gratefully acknowledge the help of fellow attorney, John Anthony Castro, J.D., LLM for bringing this case to my attention and suggesting I add it to this blog post. The Ward case demonstrates that if a US citizen marries a NRA in a jurisdiction that deems their property to be community property, the NRA spouse will become a shareholder in the corporation by operation of the community property laws. Once this happens, this will destroy the S election. In the Ward case, the spouses had in fact, executed a prenuptial agreement providing that certain property (including the corporate stock) was to remain the separate property of the US citizen spouse. The agreement was found to be unenforceable, with the result that the S corporation stock was treated as community property. As a result, the NRA spouse was treated as a shareholder, destroying the S status of the corporation.
Part II of this blog post will discuss how an inadvertent termination can possibly be prevented even though the S corporation has foreign shareholders.
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