S Corporation Operational Limitations

by John Cromwell

An S Corporation is a type of business that is registered with the IRS for a special tax status. This classification allows a business' shareholders to include a portion of the S-Corp’s income on their personal tax return, as determined by the amount of shares they own in the business. This tends to minimize the overall amount of taxes paid on business income. In exchange for this right, the S-Corp must comply with several restrictions. Some of these can influence how the business operates and its flexibility.

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Corporate Formalities

To qualify as an S-Corp, a business generally must originate as a normal corporation. Corporations are legally required to maintain strict procedures regarding decision making and hiring corporate officers. These requirements can make decision-making a long, expensive process. Further, corporations have significant state and federal reporting requirements that require significant time and effort to meet. Complying with these requirements take time and resources away from the S-Corp’s efforts to meet its operational goals.

Limits on Status

All S-Corps must be headquartered in the U.S. An S-Corp can also not be a bank, insurance company, possessions corporation, or current or former domestic international sales corporation. A possessions corporation is a U.S. corporation that does a lot of business in an American possession, such as Puerto Rico, and able to claim a tax credit as a result. A foreign domestic international sales corporation is an exporter that has registered with the IRS to obtain tax advantages.

Shareholders and Stock Limitations

S-Corps can only have 100 or fewer shareholders. Those shareholders can only be individuals, estates and certain trusts; organizations such as partnerships or corporations are not allowed to own stock. There can also only be one class of stock.These restrictions can be detrimental to an S-Corp’s attempt to raise capital for its operations. Since it can only have one class of stock, it cannot sell preferred shares that might give investors enhanced benefits. Since institutional investors cannot purchase shares, the investor pool is primarily limited to individuals.

Passive Income

Restrictions on passive income for an S-Corp only apply if prior to converting to that tax status, the corporation failed to distribute all of its accumulated earnings and profits from past years to its shareholders. If the S-Corp did not do this and its passive investment income exceeds 25 percent of its total income for a year, it must pay a 35 percent tax on the passive income. Passive income is revenue obtained from activities that an S-Corp does not participate in as part of its business. If an S-Corp received dividends from a third party tech stock, for example, the dividend is probably passive investment income. If an S-Corp earns more than 25 percent of its total revenues from passive investment income for three consecutive years, the S-Corp will lose its tax status and revert to an ordinary corporation.