Another item that could cause an entity taxed as an S corporation to lose the election is disparate distributions. Like most things, this is simple in theory but more complicated in application. The theory is that the shareholders of an S corporation are entitled only to the proportion of corporation distributions based on their percentage ownership of the stock. In other words, if you are a shareholder of an S corporation, you are entitled to the same proportion of distributions as you own shares (if you own 1/3 of the shares, you are entitled to 1/3 of the distributions).
Owners of corporations elect S corporation taxation status for the pass through and other benefits the election provides. There are various things that can arise that would cause an S corporation to lose its election. In this and following posts, I’ll walk through some of the most common. The one I want to discuss now is the S corporation passive income restriction.
I’m going to be posting a number of posts on the ins and outs of electing and operating a corporation which elects to be taxed as a small business corporation (an “S Corp”) with the IRS. There are many benefits to such an election, but there are also pitfalls that many owners run into that could jeopardize the election.
The first post in this series is simply how to make the election.
Shareholders who are employed by a corporation which has elected to be taxed as an S-Corp wear two hats. They are investors in the entity (they contributed capital to get their shares initially) and allowed to get a return on their capital, and they are employees who receive wages. When an owner/employee of an S-Corp (or an LLC which is taxed as an S-Corp) is on a salary from the S-Corp, the wages payable are subject to employment taxes, and distributions made to the owner of the S-Corp are not subject to employment taxes. Also if the S-Corp was loaned money by the shareholder, the S-Corp can make payments to repay the loan to the shareholder, and these payments will not be subject to the employment tax. Misclassifying payments as distributions or loan repayments, when they really should be wages can lead to an audit from the IRS.
In a recent case from the United States Tax Court (Glass Blocks Unlimited, TC Memo, 2013-180),