Selected Problems With The S Corporation

By Thomas Rose | Mon, 3 Nov 2008

As stated in my article entitled "Help in Choosing the Form of the Legal Entity," each form of entity presents its own advantages and its own disadvantages.  I've observed in my practice that the entrepreneurs certified public accountant frequently suggests that the new entity should be a Texas corporation, with an Internal Revenue Code election to permit the pass-through partnership treatment of income and loss (an S corporation election, or a subchapter S election, or a sub-S election).

Is there a Difference Between a C Corp & an S Corp?

First, there is no difference between the structure of a corporation organized in Texas as a C corporation or as an S corporation.  However, to invoke a federal S corporation election, there must be a timely filed Internal Revenue Code Form 2553 consent signed by all corporation shareholders. Late filing of this form has proven disastrous for some taxpayers.

S corporations are not taxed as partnerships in the following areas: (a) non-cash distributions of property are taxable events; and (b) conversions or liquidations of the entity may be taxable events.

Some Specific Problems With S Corporations?

S corporations also pose some problems or challenges: (a) S corporations are not permitted to make disproportionate allocations of income and loss among its shareholders; (b) the number of classes of outstanding stock may be limited in S corporations; (c) certain penalty taxes for built-in gains and excessive passive income may affect S corporations; (d) the federal tax election may be inadvertently forfeited; (e) a judgment creditor of an S corporation shareholder may seize such shareholders stock, jeopardizing the federal tax election status of the S Corporation; and (f) on the death of an S corporation shareholder, the S corporation may not adjust the basis of its assets to reflect the increase in the deceased shareholders basis to its fair market value as of the date of death.

When Should You Elect S Corp Status?

Do these situations mean that an entrepreneur should never select a corporation with the federal S corporation election?  No.  But the certified public accountant and the entrepreneur must carefully weigh the negative consequences of such an election before choosing to go forward.