Filing an S corp election carries many advantages (primarily avoiding two-stage tax on income). If you’ve never considered filing for S corp status before, here’s a quick recap: S corporations elect to pass corporate income, losses, deductions and credits through to their shareholders. This way, S corporations avoid double taxation on corporate income.
While an S corp election is a great way to legally avoid double taxation, there are strict rules governing formation and stringent requirements for maintaining S corp status. Violating any one of these rules (or even failing to file the election on time) can be extremely costly. The top 10 ways to destroy an S corp election range from the simple to the extremely complex.
The Basics
According to the Internal Revenue Service, the following provisions must be met for a company to qualify for S corporation status. The company must:
- Be a domestic corporation;
- Have only allowable shareholders
- May be individuals, certain trusts and estates, and
- May not be partnerships, corporations, or non-resident alien shareholders;
- Have no more than 100 shareholders;
- Have only one class of stock; and
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Violating any one of these conditions can revoke your company’s S corp status, costing you (and your business partners) time, money, and effort. While these might feel like no-brainers, complicated trust provisions, loans confused with equity, and even failure to file elections in a timely manner can quickly complicate S corp elections.
Advanced S corp destruction
From The Tax Adviser, “In general, estates and six types of trusts are eligible as S corporation shareholders, with the most common being grantor trusts (including a former grantor trust for two years post-death), electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), and testamentary trusts (for two years after funding). Most practitioners realize that a properly completed and timely filed election must be made for a trust to become an eligible ESBT or QSST, but there are many other problems that a practitioner may not easily recognize.” Here’s how issues with trusts can easily destroy your S corp election:
- A trust is owned by more than one individual. Any trust that is taxable to multiple individuals is ineligible to hold S corp stock.
- A foreign trust holds stock. Again, this may seem straightforward, but a change in trustee (or trustee control) could convert a US trust into a foreign trust.
- Using an IRA or Charitable Remainder trust as a shareholder. While these are structured as trusts for legal purposes, they are not qualified to hold S corp stock and so can invalidate your status.
- Defective trust provisions. While the trust itself may be eligible to hold S corp stock, a poorly written provision or improperly signed election can change beneficiaries, structure, or status.
- Failure to make timely elections. This is, by far, the most common way to invalidate or destroy an S corp election, and it’s not just about the March deadline. Failure to elect a trust as an eligible shareholder, failure to hold a separate election upon termination of grantor trust status, and whole host of other issues can ruin an S corp election.
The short version? There are numerous ways to destroy an S corp election, ranging from blatant errors to tiny mistakes, but there is only one good way to ensure S corp status: hire an effective and qualified business attorney.
Alex Gertsburg is a managing partner at Gertsburg Licata. He may be reached at (216) 573-6000 or at [email protected].
Gertsburg Licata is a full-service, strategic growth advisory firm focusing on business transactions and litigation, M&A and executive talent solutions for start-up and middle-market enterprises. It is also the home of CoverMySix®, a unique, anti-litigation audit developed specifically for growing and middle-market companies.
This article is for informational purposes only. It is merely intended to provide a very general overview of a certain area of the law. Nothing in this article is intended to create an attorney-client relationship or provide legal advice. You should not rely on anything in this article without first consulting with an attorney licensed to practice in your jurisdiction. If you have specific questions about your matter, please contact an attorney licensed to practice in your jurisdiction.
