S Corporation elections can be extremely beneficial to entrepreneurs. Although, like many business decisions that potentially benefit a corporation, S Corporation elections come with their share of compliance burdens and restrictions on corporate entities.

The election to be governed under Subchapter “S” of the Internal Revenue Code (IRC) is made by filing a Form 2553, an S Corporation election, with the Internal Revenue Service prior to the 15th day of the third month of the corporation’s tax year in order to be effective for a corporation’s current tax year. IRC 1362(b)(1)(B). In years for which the S Corporation election has been made, the S Corporation generally avoids double federal taxation, as the entity only incurs taxation on the shareholder level. IRC 1363(a)-(b). The shareholders report their share of the S Corporation’s income, deductions, and losses on their own tax returns. S Corporation status also enables shareholders to take immediate deductions for the corporation’s losses, which is ideal for capital intensive start-ups. IRC 195. Finally, avoiding double taxation upon the sale of corporate assets strongly strengthens the allure of an S Corporation election. S Corporation entrepreneurs, whether building a start-up with an eye to eventual sale or operating a family-based business, often realize important tax savings through an S Corporation election.

As alluded to above, not every corporation can or should make an S Corporation election. S Corporations must meet the following criteria:

(A) An S Corporation is limited to 100 shareholders;
(B) Those shareholders are limited to individuals, certain qualifying trusts, like a Grantor Trust, Qualifying Subchapter S Trust (QSST), or an electing small business trust (ESBT), and estates of deceased shareholders;
(C) An S Corporation can only have one class of stock;
(D) An S Corporation must be a domestic corporation; and
(E) An S Corporation must not be an ineligible type of corporation (generally, banks, insurance companies, or international sales companies). IRC 1361(b)(1).

An often ignored compliance issue is in maintaining S corporation status, usually which typically implicates either the type of shareholder or one class of stock limitations.

Type of shareholder issues arise as shareholders implement estate plans and transfer stock to trusts or family members. One particular type of shareholder issue that shareholders should be aware of is the 2-year window in which to deal with shares held in trust following the death of the shares’ owner. IRS Reg. 1.1361-1. IRS regulations require that shares held in trust must be transferred out of the trust or the trust must make a QSST or ESBT election to retain the shares. IRS Reg. 1.1361-1.

One class of stock issues more typically come into play where venture capitalists or angel investors seek preferred stock with liquidation preferences or anti-dilution provisions.

Both issues can be proactively addressed. In dealing with “shareholder type” issues, a buy-sell agreement or shareholder agreement can help restrict transfers that would otherwise invalidate an S corporation election. To address “one stock” issues, creative investing can be utilized to avoid or postpone the termination of an S Corporation election. For example, convertible debt can be utilized in some instances to mimic the attributes of preferred stock. Alternatively, a shareholder agreement can, in other instances, achieve a similar result to issuing preferred stock. In any case, maintaining an S Corporation election requires attentiveness to details and proactive action to avoid inadvertent termination and loss of S Corporation benefits.

To maintain its S Corporation status, a business should:

• Execute a buy-sell or shareholders agreement that restricts transfers of shares without approval of the other members.
• Increase shareholder awareness of the effect of callous estate planning on a corporation’s tax status.
• If shareholder stock was kept in a trust, be aware of the 2-year window following a shareholder’s death in which to transfer the stock out of the trust or make a QSST or ESBT election.
• Actively examine and plan for alternative investment approaches for venture capitalists and angel investors to delay the termination of a corporation’s S Corporation status.
• Include a timeline for S Corporation status termination in budgeting and strategy planning.

Daniel Huntley is an associate attorney at WilliamsMcCarthy LLP, advising small-to-medium size businesses on start-up and corporate law issues, and additionally serving clients in the areas of trust and estates, and agribusiness law issues.