Did your business make an election to be treated as an S Corporation for tax purposes? Here are a few gotcha's that can terminate your election if you aren’t careful. The tax law standard is that you have to meet the qualifications of being an S Corporation on every day of the tax year. What qualifications? The same criteria you checked off before electing S, has to continue to be true throughout each tax year you want to continue filing as an S Corporation. We outlined the S Corporation requirements in our previous video, Can you elect S Corp? The three requirements that companies struggle with the most are:
1. There cannot be a second class of stock.
2. Undocumented loans between owners and the business.
3. Owners must be “allowable,” shareholders.
The second class stock is by far the most common issue I see S Corporations deal with. The meaning of this rule is that all owners, have to receive the same right to distributions and liquidation proceeds, commensurate with their relative shares of the company’s stock. For example, if someone owns 10% of the outstanding shares, they should receive 10% of the distributions from the company. If your S Corporation is an LLC under state law, then we would expect an owner’s share to be measured by their membership units compared to the total. This concept can be a transition for LLC owners who were previously taxed under partnership rules. Under the tax partnership rules, it’s possible for owners to receive distributions in any particular year that are disproportionate in comparison to their percentage of membership units. If an S Corporation gives owners disproportional rights to distributions, it has violated the second class of stock rule which causes an inadvertent termination of the S Election.
Watch the video for more information on the topic.
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