Redefining S Corporation Eligibility for the 21st Century

Corporations are generally subject to two levels of tax: once at the corporate level and again at the individual level when corporate earnings are distributed. Certain corporations may elect under Subchapter S of the Internal Revenue Code to be subject to a regime in which the earnings are generally taxed only once to the individual owners of the corporation. The Subchapter S rules acknowledge the unfairness and inefficiency of the double taxation of C corporations, especially those that are debt financed; however, because of the limitations on eligibility, Subchapter S does not go far enough in allowing small businesses to compete on a tax-neutral basis. A corporation is not eligible to elect S status unless it has only one class of stock, no non-resident alien (NRA) shareholders, and no non-individual shareholders.

Partnerships (and LLCs taxed as partnerships) are taxed in a manner similar to S corporations except they may have NRAs and non-individuals as owners, as well as multiple classes of interests. Notably, the popularity of such entities belies the notion that pass-throughs are too complicated for typical corporate structures. Accordingly, we would like to see S corporations taxed more like partnerships, thus removing a tax artificiality from the choice of entity decision and allowing companies to conduct business in the most efficient form.

To neutralize tax considerations regarding choice of entity, S elections should be made available to a greater number of small businesses by allowing corporations with preferred stock, NRA shareholders, and non-individual shareholders to be eligible to elect S status. Removing these arbitrary limitations on eligibility would make the S election available to the existing class of taxpayers who are either stuck with the LLC form of doing business or forced to pay taxes twice on the same income. Thus, our proposal is to amend the Code to remove the requirements that an eligible corporation can only have one class of stock, and only U.S. individual shareholders, in order to bring the tax treatment of small business entities into the 21st century.

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