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The Lurking Pitfalls of S Corporations

If you are thinking about starting a new business, or already own stock in a S Corporation, you should familiarize yourself with some of the potential issues that you may face in the future.

A S Corporation affords the limited liability of a corporation under state law, but, unlike a normal C Corporation, comes with the added advantage of only one level of tax to the owners. Upon hearing this, you may think “Sounds like the best of both worlds!”

However, there are many rules that a S Corporation must follow. Some of them are rarely violated, such as not having over 100 shareholders or not having a nonresident alien as a shareholder. But two rules in particular seem to cause problems: (1) the S corp can only have one class of stock, and (2) the S corp shareholders can only be individuals (there are some limited exceptions to this that will not be covered here).

First, having one class of stock means that all shareholders must receive a portion of all distributions issued by the S Corporation based on their ownership percentage, and that all shareholders must share in any liquidation proceeds based on ownership percentage if the company is ever dissolved. This requirement means that you cannot limit distributions to only select shareholders. Note that the one class of stock rule does not prohibit the establishment of separate voting and non-voting stock.

Second, some shareholders may eventually want to transfer their shares to an entity such as a LLC or a different corporation, whether for estate planning purposes, tax reasons, investment opportunities, etc. But because of the rigid restrictions, owning shares of a S Corporation limits your flexibility to structure such transactions.

Violating the S Corp rules, even if inadvertently, means that your company could be subject to owing back taxes and penalties to the IRS. If you have not created an entity yet, be sure to consult with an attorney and an accountant to decide if a S Corporation is truly right for your situation. And if you already have a S Corporation, it is a good idea to consult with an attorney to review or create a shareholders agreement that protects against violation of the S Corporation rules.