And here’s why: S corporations provide great tax savings, but unfortunately they come with some pretty severe restrictions: limits on numbers of shareholders, rigid rules about splitting profits, and then tight restrictions on the sort of people who can become owners.
However, you probably have a workaround to most or even all of these restrictions. You can use an S corporation partnership… by which I mean, just to be clear, a partnership that has as its partners, S corporations.
In this blog post, therefore, I’m going to identify the three big restrictions on S corporations and then describe how you can use an S corporation partnership as a workaround.
S Corporation Partnerships & Limit on Shareholders
Let me start off with the limit on the number of shareholders restriction. As you may know, tax law limits the number of shareholders an S corporation may have to 100 shareholders. You can’t have an S corporation with 200 shareholders, for example. Or one with 1000 shareholders. Those shareholder counts break the rule.
A partnership of S corporations lets you sidestep this limit, however. For example, say you want to run some venture as an S corporation but you have 200 shareholders. What you can do is set up a partnership with two partners—each partner being an S corporation with 100 shareholders.
In this case—and the tax accounting will be just a little more work—you can run your 200-shareholder business using all the benefits of an S corporation even though you’re over the 100 shareholder limit.
Note that this partnership of S corporations approach means you could have, theoretically, any number of owners benefiting from the S corporation tax accounting treatment. If you wanted to use the S corporation gambit for a business owned by, say, 500 shareholders, you could create a partnership of five S corporations, each with 100 shareholders.
A final note about the shareholder limit restriction: As practical matter, the 100 shareholders limit doesn’t work quite the way you would at first think because a family of shareholders often, for purposes of the 100 shareholders limit, counts as a single shareholder.
S Corporation Partnerships & Multiple Classes of Stock
Let me move onto using an S corporation partnership to work around another common restriction.
S corporations require you to treat all the owners the same way in terms of their shares of the firm’s operating profits, liquidation profits, and distributions of those profits.
With an S corporation, if some shareholder owns 10% of the business, he or she gets allocated 10% of any profits. And he or she must get 10% of any distributions paid out to shareholders.
This seems a subtle thing, but the one class of stock deal often greatly restricts owners from slicing and dicing profit allocations and distributing profits in the way they would like.
You can’t with an S corporation create a profit allocation formula that allocates profits or distributions on some basis other than ownership percentage.
Just so you understand what I mean here, suppose you have a couple of entrepreneurs, Tom and Jeff. Tom does more of the actual work. But Jeff contributed the working capital and bought in the first customers.
In a situation like this, you might like to create a profit sharing formula that worked like this:
- The first $50,000 of profits goes to Tom.
- The next $25,000 of profits goes to Jeff.
- The next $75,000 of profits get split 2/3rds to Tom and 1/3rd to Jeff.
- Any profits after that get split 50% to Tom and 50% to Jeff.
But you can’t split profits this way in an S corporation. You’d be treating shareholders differently which would violate the one class of stock restriction.
Note: Sometimes people try to backdoor their way into a profit sharing arrangement like I described above by splitting profits 50% to Tom and 50% to Jeff but adjusting salaries to deal with all the other variability. This approach may work on paper. But it’s often impractical. And the approach also mucks about potentially with the requirement to pay shareholder’s reasonable compensation.
With S corporation partnerships, however, you have no such problems. You would do the profit sharing calculations at the partnership level. Each S corporation partner would then get a share of the profits. And then, within that S corporation, all of the profits and all of the distributions would go to the S corporation’s single shareholder.
With a single shareholder S corporation, you would not even have the ability to treat shareholders differently. Using the examples of Tom’s S corporation and Jeff’s S corporation, Tom’s S corporation will treat all of this shareholders the exact same way—because of course there’s only one shareholder in Tom’s S corporation, Tom.
Ditto for Jeff’s S corporation. Jeff’s S corporation will treat all of its shareholders the exact same way.
And just to make this point… It won’t matter that Tom’s S corporation and Jeff’s S corporation treat their shareholder’s differently. The two S corporations are different entities.
S Corporation Partnership & Ineligible Shareholders
As you maybe know, only U.S. citizens, permanent residents and a handful of other taxpayers that sort of look like or resemble U.S. citizens and permanent residents can own shares in an S corporation.
If three U.S. citizens, Olympia, Susan and Diane, want to operate their venture as an S corporation, for example, they probably can.
However, if it turns out that these three women want to form an S corporation but one of the woman—say Diane– isn’t a U.S. citizen or permanent resident then they can’t form an S corporation.
Except there’s an easy workaround which you can now guess that, right? They can use an S corporation partnership. The partnership’s partners will include Olympia’s S corporation, Susan’s S Corporation and then Diane, the individual. Problem solved.
Note: I’ve got a bit more discussion of who is and isn’t an eligible S corporation shareholder at the S corporations explained FAQ:
You probably want professional help structuring any S corporation partnerships. As you might guess, some accounting complexity exists with this arrangement. And some gotchas can blindside you and your partners if you’re not careful.
However, if you’d like to use an S corporation but find yourself seemingly blocked by one of the common restrictions, keep in mind that an S corporation partnership may just give you a way to sneak around the restrictions.
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