S Corporations . . .

are a special kind of corporation identified in the Internal Revenue Code that are taxed differently from the more customary C corporations most people think of when they think of corporations.

S corporations differ from C corporations in one important particular: They are not taxed by the IRS as entities separate and distinct from their shareholders. In S corporations, the income and losses of the company pass directly to its shareholders. If the company earns $100,000 in profits during the year, its 50 percent shareholder would be responsible for showing 50 percent of the profit, or $50,000, on his personal tax return as income. If the company lost money during the year, each of its shareholders would be entitled to claim a portion of the company’s losses on his individual tax return as a loss.

These profits and losses pass directly to the shareholders without regard to whether or how much money the company distributes to them. If the company makes a profit and needs it to fund operations, the shareholders will have to show that profit on their individual tax returns and pay taxes on it even though they receive no cash. Agreements can be made among shareholders and management to require cash payments that are sufficient to pay taxes.

In the past, when maximum individual tax rates exceeded corporate maximum tax rates, S corporations were used primarily during the early stages of company development while losses exceeded profits. When individual tax rates fell below corporate tax rates under 1986 tax reform, S corporations came to be used in many cases to actually reduce federal taxes paid on corporate earnings by giving the company the benefits of its shareholders’ lower maximum tax rates. Appropriate use of the S form will always depend, in part, on the relative tax rates of corporations and individuals. These rates are always subject to change.

The S form can reduce the cost to the shareholders of their investments in a company that is losing money by allocating back to those shareholders the company’s losses in its first years. These losses can be used by the shareholders to reduce their income tax obligations and thereby effectively reduce their after-tax cost of investment. At the same time, however, the company loses the ability to use these losses to shelter future income from taxes and thereby increases the likelihood that it will need additional funding in the future.

S corporations are not particularly effective at attracting outside investors with the promise of allocating company losses to them to reduce their taxes. This is because losses and profits are allocated to S company shareholders on the basis of the number of shares held. In other words, an outside investor will only receive a portion of the company’s losses equal to his percentage ownership. If he puts in $1 million and gets 40 percent of the stock he will get only 40% of losses generated by the company’s use of his money. If the company loses all of his $1 million, he will only get $400,000 of it.

Other devices, such as limited partnerships and limited liability companies, permit more flexibility in the allocation of losses and profits and consequently are used more often than S corporations to attract investors who want to reduce the after-tax cost of their investments. Limited partnerships and limited liability companies can be structured so that almost all of the company’s losses are allocated to the outside investor. This means an investor who purchases a 40% interest in a limited entity could, nonetheless, receive almost all of the losses attributable to the use of his $1 million even though he may only be entitled to receive 40 percent of the profits.

Establishing an S corporation requires strict compliance with a number of IRS requirements, including rules relating to the nature of the company’s shareholders and its outstanding securities, and may not be available to all entrepreneurial companies. For example, S corporations are available only to companies organized under the laws of a state. Foreign corporations, even if they have assets or do business in the United States, cannot qualify. Even some domestic companies defined by the IRS as "ineligible corporations" (e.g., insurance companies, certain financial institutions, and other enumerated companies) cannot qualify. S corporations can have no more than 75 shareholders, all of whom must be individuals, estates, or certain qualifying trusts or tax exempt organizations. And only one class of stock can be issued without jeopardizing the S corporation’s tax status (although that class can be divided into subclasses with different voting rights). Certain consent and timing requirements must also be met to secure S corporation status.

As you might imagine, the flow-through of profits and losses is not without complications. For one thing, losses can be used by a shareholder only to the extent of his "basis" in his stock. Initially, this basis equals the individual’s purchase price for his stock plus his basis in any loans he makes to the company. As the company operates, this basis can fluctuate, however, generally increasing with company income and gains and decreasing with company losses. Also, losses generated to a shareholder may not be used to offset all types of income.

Because of the complexity of S corporations and the peculiarities of the manner in which they and their shareholders are taxed, entrepreneurs should always consult with their accountants and legal advisers before organizing S corporations. Failure to do so could result in unwanted surprises for the company and its shareholders. See: Limited Partnerships, LLCs (Limited Liability Companies), R & D Partnerships, Structure.