Skip to main content

Site Navigation

Site Search

global Tax

S Corps Beware: Diligence Needed to Avoid Inadvertent Loss of Tax Benefits

February 15, 2022

S corps benefit from many of the same tax benefits as partnerships…but what due diligence is required to maintain these benefits? We explore here.

S corporations enjoy the best of two worlds. They get the favorable tax treatment of so-called “pass-through entities,” and their owners receive the legal protection of traditional C corporation owners. But there’s also a downside to this ownership structure: You must adhere to strict rules to maintain this status — and if you make a misstep, your Subchapter S election may be terminated. Here are some important reminders for S corps.

What Are the Tax Benefits?

S corps benefit from many of the same tax benefits as partnerships. Namely, all of their profits and losses are passed through pro rata to the owners on their personal income tax returns. By comparison, the earnings of traditional C corporations are taxed twice, first at the corporate level and again when income is distributed to shareholders. The downside, of course, is that S corp owners must pay their share of the company’s tax bill personally even if they receive no cash distributions for the tax year.

It’s important to note that S corps differ from partnerships in a few key respects. First, S corps must allocate profits and losses and pay distributions to their shareholders based on their relative ownership percentages. In addition, S corps owners aren’t required to pay self-employment taxes on their shares of the profits — as long as they’re paid “reasonable” compensation for services rendered to the company. This issue can be a hot button if the IRS audits your returns.

Even with the flat 21% corporate tax rate under the Tax Cuts and Jobs Act (TCJA), many private business owners still prefer operating as S corporations. The qualified business income (QBI) deduction helps level the playing field for many businesses from 2018 through 2025.

Who Qualifies?

To qualify as an S corporation, all of your shareholders must sign and file IRS Form 2553, “Election by a Small Business Corporation.” Your business also must:

  • Be a domestic corporation,
  • Have no more than 100 shareholders (family members may be treated as a single shareholder for this purpose),
  • Have only “allowable” shareholders (including individuals, estates and certain trusts),
  • Have only one class of stock (differences in voting rights may be permissible), and
  • Not be an “ineligible” corporation, such as an insurance company, a domestic international sales corporation or a certain type of financial institution.

The rules for trust shareholders are complicated. Foreign trusts aren’t allowed to own S corp shares. If your company’s shareholders include a domestic trust, our tax professionals can help ensure that it qualifies as an allowable shareholder under current tax law.

Diligence Pays

S corps must continuously monitor their shareholders and activities to prevent inadvertent loss of their favorable status. Minor mistakes can have major tax and legal implications. Proactive measures — such as drafting buy-sell agreements that prohibit stock transfers to ineligible shareholders and avoiding disproportionate year-end distributions — can help preserve S corporation status.

However, if your S corp does trigger an inadvertent termination, our tax specialists may be able to seek relief from the IRS and potentially restore your S status retroactively. Contact us for more information.

Stay informed. Get all the latest news delivered straight to your inbox.

Also in Tax Blog

up arrow Scroll to Top