1.4 S-Corporations

From the corporation it takes limited liability and the corporate form itself. An S corporation is a corporation: chartered under state law, separate from its shareholders and officers, with the same shield around its owners' personal assets. A shareholder's exposure is generally capped at what they invested.

From the partnership it takes pass-through taxation. Apart from tax on certain capital gains and passive income, the entity pays no federal income tax. Its income, deductions, gains, losses, and credits flow through to the shareholders on Schedule K-1, and they pay tax at their own rates — the same single layer of tax a partnership gives.

Which body of law supplies each. State law creates the corporation and supplies the liability shield; the charter is a state document. Federal tax law — Subchapter S of Chapter 1 of the Internal Revenue Code — supplies the pass-through treatment, and it is a treatment the corporation must affirmatively elect on Form 2553.

Answer: Limited liability and the corporate structure come from the corporation side, granted by state statute; pass-through taxation comes from the partnership side, granted by federal tax law.

What Form 2553 does. Form 2553, Election by a Small Business Corporation, is the filing by which an eligible corporation asks the IRS to tax it under Subchapter S. Nothing about the entity's legal existence changes — it stays a corporation under state law with the same shield. What changes is that the corporation stops paying federal income tax at the entity level and its income begins passing through to shareholders.

Who must sign it. All shareholders must sign. The Instructions for Form 2553 specify the required information along with the filing deadline and where to file.

Why unanimity makes sense. The election rewrites every shareholder's personal tax return. Once S status is in effect, each shareholder owes tax on their allocated share of corporate income whether or not the company ever distributes a dollar of it. A shareholder could therefore end up with a tax bill and no cash to pay it with. Because the election imposes that liability on each owner individually, the law will not let a majority impose it on a minority — every owner must consent.

Answer: Form 2553 elects Subchapter S taxation; every shareholder must sign it, because the election moves the tax bill onto each shareholder's own return whether or not profits are distributed.

The corporation must satisfy all five requirements below. Failing any one of them makes the election unavailable.

1. It must be a domestic corporation — organized in the United States. Disqualified: a corporation chartered in another country, however small or closely held.

2. It may have only allowable shareholders — individuals, certain trusts, and estates. Partnerships, corporations, and non-resident aliens may not be shareholders. Disqualified: a joint venture whose ownership is held through an LLC or partnership, or a business with a shareholder living abroad who is not a U.S. resident.

3. It may have no more than 100 shareholders. Disqualified: an employee-owned company that has spread stock across several hundred workers.

4. It may have only one class of stock. Disqualified: a start-up that has issued preferred stock carrying a fixed dividend to its investors — that preferred stock is a second class.

5. It must not be an ineligible corporation — the statute excludes certain financial institutions, insurance companies, and domestic international sales corporations. Disqualified: an insurance carrier.

Answer: Domestic corporation; only individual, trust, or estate shareholders; no more than 100 shareholders; a single class of stock; and not an ineligible corporation. Each rule pushes the S corporation toward small, closely held, U.S.-owned businesses.

a) Yes — it meets every requirement. It is domestic, all 72 shareholders are allowable individuals, 72 is under the 100-shareholder cap, and there is one class of stock. Nothing bars the election.

b) No — the allowable-shareholder rule. A corporation may not be a shareholder of an S corporation. Only individuals, certain trusts, and estates qualify. The count (25) is fine; the type of owner is not.

c) No — the 100-shareholder cap. With 104 shareholders it is over the limit, even though every one of them is an allowable individual. It would have to fall below 101 shareholders before electing.

d) No — the single-class-of-stock rule. Preferred stock is a second class, so a corporation with both voting common and non-voting preferred stock is ineligible. (Note that differences in voting rights alone within one class do not create a second class — it is the preferred stock's different economic rights that do.)

e) No — the allowable-shareholder rule again. A non-resident alien may not be a shareholder. One such shareholder out of four disqualifies the whole corporation.

Answer: Only (a) qualifies. (b) and (e) fail the allowable-shareholder rule, (c) fails the 100-shareholder cap, and (d) fails the single-class-of-stock rule.

Why the S election is unavailable. The start-up's funding plan collides with two of the five eligibility requirements at once:

• Only one class of stock. Preferred stock — with its fixed dividend and liquidation preference — is a second class of stock. Issuing it makes the corporation ineligible, and preferred stock is exactly what venture investors expect to receive.
• Only allowable shareholders. Venture-capital funds are almost always organized as partnerships (or as LLCs taxed as partnerships). A partnership may not be a shareholder of an S corporation, so the moment a fund takes stock the election is lost.

A third pressure follows close behind: the 100-shareholder cap, which a company raising through multiple rounds and issuing employee equity can cross faster than founders expect.

What it should use instead. A C corporation (§1.5). The C corporation has no cap on shareholder count, no restriction on entity or foreign owners, and may issue multiple classes of stock including preferred. The price is the double taxation of §1.5.1 — corporate-level tax, then tax again on dividends — which is the trade a venture-backed company accepts in exchange for being able to raise capital at all.

Answer: Preferred stock violates the one-class-of-stock rule and venture funds violate the allowable-shareholder rule, so the S election is off the table; the company should incorporate as a C corporation.

a) About $55,000, paid as wages. Because Esteban performs services for the corporation, he is its employee, and the corporation must pay him reasonable compensation — a salary reflecting the value of the work he actually does — before any profit is distributed. The comparable-role figure of $55,000 is the natural benchmark. That salary runs through payroll and bears payroll (employment) taxes: the Social Security and Medicare taxes split between the corporation and Esteban. It is also subject to ordinary income tax.

b) About $35,000.

The $35,000 remaining after reasonable compensation passes through to Esteban as a distribution. It is subject to income tax on his personal return, but generally not to payroll or self-employment tax.

c) All $90,000. A sole proprietor pays self-employment tax on the business's entire net profit — there is no salary/distribution split to make. Shielding $35,000 from that tax is precisely what the S election bought him.

Answer: Roughly $55,000 as payroll-taxed wages, about $35,000 passing through free of payroll tax, versus the full $90,000 bearing self-employment tax as a sole proprietorship.

The rule in plain terms. A shareholder who actually works in an S corporation is treated as its employee, and the corporation has to pay them a real salary — one that reflects what the work they do is genuinely worth, measured against what the same job pays elsewhere — before handing them any pass-through profit as a distribution.

Why the IRS scrutinizes low salaries. The two envelopes an owner-employee receives are taxed differently. Wages bear Social Security and Medicare taxes; distributions of the remaining pass-through profit generally do not. So every dollar an owner moves out of the salary column and into the distribution column is a dollar that escapes payroll tax. An owner who pays themselves an implausibly small salary is not doing clever planning — they are understating employment taxes, and the pattern is easy for the IRS to spot: full-time work, high profit, token paycheck.

What the corporation is risking. The IRS can recharacterize the underpaid portion of the distribution as wages. That brings back the employer and employee shares of the payroll taxes that should have been paid, plus interest and penalties, and it invites scrutiny of other years. There is no safe fixed percentage to hide behind — "reasonable" depends on the role, the industry, the hours, and comparable pay.

Answer: The owner-employee must be paid a defensible market-rate salary before taking distributions; the IRS watches low salaries because they convert payroll-taxed wages into payroll-tax-free distributions, and it can recharacterize the shortfall as wages with back taxes, interest, and penalties.

What they share: a single layer of tax with limited liability. Both give their owners a liability shield while the entity itself pays no federal income tax — income, deductions, gains, losses, and credits pass through to the owners, who pay at their own rates, whether or not the cash is distributed.

Two ways they differ:

• The reasonable-compensation / payroll-tax split. An S-corporation owner who works in the business is an employee, must be paid a defensible salary, and pays payroll tax only on that salary — the remaining profit is distributed free of payroll and self-employment tax. An LLC member taxed as a partner has no such split; a general partner's share of the business's earnings is subject to self-employment tax.
• Ownership and formality. An LLC has essentially no ownership restrictions — any number of members, of nearly any type, including other entities and foreign owners — and no mandatory corporate formalities. An S corporation is capped at 100 shareholders, admits only individuals, certain trusts, and estates, allows one class of stock, and must be maintained as a corporation.

When each is preferred:

• Prefer the S corporation when the business is consistently profitable well above what the owner's own labor is worth. Once profit comfortably exceeds a reasonable salary, the payroll-tax saving on the distribution portion is real money every year — the situation in Problem 1.4.6.
• Prefer the LLC taxed as a partnership when ownership is complicated or profits are modest: an outside investor that is itself an entity, a foreign member, members who want unequal or shifting allocations, or a business whose profit barely exceeds a reasonable salary and so has little distribution left to shelter. The LLC's flexibility is worth more than a payroll-tax split that would save almost nothing.

Answer: Both offer limited liability plus pass-through taxation; they differ in the S corporation's reasonable-compensation payroll-tax split and in the S corporation's strict ownership and formality rules. Choose the S corporation for a solidly profitable owner-operated business, and the LLC when ownership flexibility matters more than the payroll-tax saving.