S corporations have a lot of tax benefits since the company’s income and losses are “passed through” to the shareholders’ personal tax returns, avoiding the double taxation loop that affects corporate income.
However, S corps have to meet specific requirements with the Internal Revenue Service (IRS) to retain their status – and it’s painfully easy to unintentionally cross a line. Here are some problems that could cost your company its S corp status:
Exceeding the shareholder limit
S corps are limited to a maximum of 100 shareholders. This may seem like a lot, but you could inadvertently exceed this limit by issuing new shares without tracking the number of shareholders or when shareholders sell their stock to multiple parties.
Having non-eligible shareholders
S corporations have to be domestically owned, so only U.S. citizens, lawful resident aliens, certain trusts and estates can be shareholders. If one of your shareholders loses their resident alien status or changes their citizenship, your S corp status can be revoked.
Issuing a second class of stock
S corps are only permitted to have one class of stock, but you could unintentionally create a second class by extending different voting rights to certain shareholders or offering new options in dividend distributions or liquidation rights. That can lead to your S corp status being revoked.
Mistakes in tax filings
Failing to adhere to specific tax requirements for S corporations can easily lead to the loss of your status. Common mistakes include having too much passive income, misreporting income or expenses or failing to file necessary forms on time.
Working with knowledgeable professionals who understand the intricacies of S corporations and how they need to be managed as they change and grow can help you navigate a lot of the common pitfalls that lead to significant financial and operational consequences. Legal guidance is essential.