by Richard Keyt, Arizona LLC, corporate and business lawyer
This article is part of a series of nine related articles I wrote about the seven types of entities used in Arizona to operate a business and to hold business assets and investment real estate. The articles are: (1) the “Best” Arizona Entity, (2) limited liability companies, (3) sole proprietorships, (4) general partnerships, (5) limited partnerships, (6) C corporations, (7) S corporations, (8) business trusts, , and (9) the entity comparison table. The type of entity can have significant income tax and asset protection consequences. The articles discuss the entities in terms of ease and cost of formation, number of owners & restrictions on ownership, privacy, control and management, owners protection from liabilities of the entity, and federal income taxation issues.
Ease of Formation & Cost
An S corporation is formed in Arizona exactly the same way as a C corporation, except that after formation, the stockholders of the corporation file an election with the IRS to have the corporation be taxed under Subchapter S of the Internal Revenue Code of 1986. See the discussion on the ease and cost of forming a C corporation.
The stockholders of a qualified corporation may elect S corporation status for federal income tax purposes by filing IRS Form 2553 (pdf), Election by a Small Business Corporation. There are several requirements that must be met before a corporation can elect S corporation status. For more information, see IRS Instruction for Form 2553 (pdf), Election by a Small Business Corporation.
To elect S corporation taxation, all the stockholders must complete and file IRS Form 2553 with the IRS:
- at any time before the 16th day of the 3rd month of the tax year, if filed during the tax year the election is to take effect, or
- at any time during the preceding tax year.
An election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2 and 1/2 months long is treated as timely made for that tax year. An election made after the 15th day of the 3rd month, but before the end of the tax year is effective for the next year. For example, if a calendar tax year corporation makes the election in April 2001, it is effective for the corporation’s 2002 calendar tax year.
Number of Owners & Restrictions
A corporation may not be an S corporation if it has more than 100 shareholders. A husband and wife (and their estates) are treated as one stockholder. All stockholders must be individuals, estates, exempt organizations described in Internal Revenue Code Sections 401(a) or 501(c)(3) or certain trusts described in Section 1361(c)(2)(A). No stockholder can be a nonresident alien. The corporation must not have more than one class of stock. The corporation must have a tax year end of December 31 unless a different year end was approved by the IRS. Every shareholder of a corporation (including spouses with community property interests) that seeks to be an S corporation must consent in writing on Form 2553 to adopting S corporation status.
Control & Management
Stockholders own a corporation, but the Board of Directors is responsible for managing the corporation. The stockholders elect the members of the Board of Directors at the annual meeting of stockholders. The officers of a corporation are responsible for the day-to-day operations of the corporation, and they report to and serve under the guidance of the Board of Directors.
A corporation has the most on going and expensive maintenance requirements of any Arizona entity. Arizona law requires that the stockholders hold an annual meeting. Directors should meet as often as necessary to manage the corporation and oversee the officers, but not less than once a year. Meetings of stockholders and directors must be called by giving proper notice pursuant to the procedures set forth in the Bylaws of the corporation. A quorum at each meeting is necessary to conduct a meeting and to approve any action. All meetings of directors and officers should be documented with written minutes signed by the appropriate people. Minutes and adopted resolutions should be kept in a minute book.
Arizona corporations must have a statutory agent, file an annual report with the ACC and pay a $45 fee. If the annual report is not filed timely, the ACC assesses a penalty and will eventually revoke the charter of a corporation that does not file its annual report.
Every year an Arizona corporation must file an annual report with the Arizona Corporation Commission. The annual report must state the names and addresses of all: (i) stockholders that own 20% or more of the stock, (ii) the directors, and (iii) the officers. This information is a matter of public record available on the ACC’s website.
Owner’s Protection from Liabilities
The general rule is that the stockholders, officers and directors of a corporation are not liable for the corporation’s obligations and liabilities. There are exceptions to this general rule such as directors may be liable for authorizing improper or illegal conduct.
There is a legal concept called “piercing the corporate veil,” which is the term given when a court disregards the corporate shield that normally protects stockholders from liability and imposes liability on one or more stockholders. When a court pierces the corporate veil, it is usually because the stockholders, officers and directors have not followed the formalities of operating in the corporate form. The risk of having the corporate veil pierced is why it is very important that corporations hold properly called and documented annual and special meetings of stockholders and directors and that they file their annual reports and pay the filing fee timely.
Federal Income Taxation
The only reason stockholders elect to be taxed as an S corporation is to have an entity that, as a general rule, is not a taxpaying entity for federal income tax purposes. An S corporation is taxed for federal income tax purposes like a partnership.
An S corporation may owe income tax in the following instances:
1. If, at the end of any tax year, the corporation had accumulated earnings and profits, and its passive investment income under section 1362(d)(3) is more than 25% of its gross receipts, the corporation may owe tax on its excess net passive income.
2. A corporation with net recognized built-in gain (as defined in section 1374(d)(2)) may owe tax on its built-in gains.
3. A corporation that claimed investment credit before its first year as an S corporation will be liable for any investment credit recapture tax.
4. A corporation that used the LIFO inventory method for the year immediately preceding its first year as an S corporation may owe an additional tax due to LIFO recapture.
The profits and losses of the S corporation are passed through to its stockholders pro rata based on each partner’s percentage ownership of stock. For example, if two people own 25% and 75%, respectively, of the stock of an S corporation and the S corporation has $100 of profit at the end of the year, the profit is allocated $25 to the 25% stockholder and $75 to the 75% stockholder. Stockholders must include S corporation tax items on their personal federal income tax returns.
Unlike a partnership or a limited liability company, the stockholders cannot agree to make special allocations among them of tax items such as profits and losses. If a special allocation of profits, losses or other tax items is important to any potential stockholder, the stockholder should consider forming an Arizona limited liability company instead of a corporation.
Although an S corporation is not usually a taxpaying entity for federal income tax purposes, it must file an in informational tax return on IRS Form 1120S to notify the IRS of its profits, losses and other tax significant items. For more information on the federal income taxation of partnerships, see IRS Publication 542, Corporations.
This article is a general discussion of the characteristics of S corporations. The article is not specific advice. Before choosing your new entity, you should consult with your accountant and business attorney and discuss your options and choose the type of entity that is best for you in light of your particular facts and circumstances.