The Risks of Losing Legal S-corp Status

Most often, when somebody files to create a business, they are filing as a cooperation (C-corp) or an LLC. A C-corp requires stock issuance, a board, and stock holders. An LLC involves members who are owners with no stock holdings. Either one can be registered with the federal government as an S-corp. An S-corp is simply a tax status with the federal government.

If an S-corp status is received from the federal government, it is important to preserve that status. If the S-corp status is lost for any reason, it cannot be obtained for five years. During that time, the federal government will tax the entity as a C-corp, even if it was originally an LLC. The loss of an S-corp status will result in transformation from what is generally the most favorable tax status to the least favorable tax status.
To qualify as an S-corp and take advantage of the tax benefits associated with an S-corp, a few elements are required. Failure to follow these elements will risk the loss of the favorable S-corp status.

First, an S-corp must have no more than one hundred owners. This means that a C-corp that is registered as an S-corp could not have more than one hundred shareholders. An LLC cannot have more than one hundred members. Simply put, there must be one hundred or fewer owners of the business to have S-corp status.

To qualify for S-corp status, the owners must be U.S. citizens or legally residing in the U.S. No person who lives outside the U.S. and is not a U.S. citizen can become an owner.

Additionally, the owners must generally be individuals, or a living trust owned by an individual. An S-corp cannot be owned by another business, with limited exceptions.

An additional requirement is that there be no preferred status for any owner, such as preferred stock or disproportionate LLC distributions. Every owner must receive distributions according to their percentage of ownership. Distributions according to stock ownership must be in accordance with common stock principals, where everyone receives dividends according to the number of shares they hold. Distributions of profits to LLC members must be in proportion to their ownership in the LLC. Certainly, varying salaries can be received for work provided by the owner as an employee, which is handled separately.

If you have any questions about obtaining an S-corp tax status, it is best to consult with an accountant and legal counsel to ensure that you comply. We are certainly pleased to assist with any questions, document preparation, or management decisions for an S-corp.

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