S corporations technically can have only one class of stock for a limited number and type of shareholder. S Corporations may issue stock to no more than 100 shareholders, all of whom must be U.S. citizens, resident aliens or certain types of trusts or non-profit entities. Not only do these restrictions preclude S corporations from receiving equity financing and investment from U.S. corporations, non-U.S. investors and/or certain types of trusts, but they also prohibit S corporations from issuing preferred stock, profit interest (also known as carried interest) or other forms of preferential equity or financial benefit unique to some of their shareholders.
2. Contributions of property, sales or liquidation of shareholder interest and distributions of profits from S corporations trigger taxable events. Contributions of appreciated property to an S Corporation are subject to tax when the contributing shareholder owns less than 80 percent of the corporation’s majority vote and value after the transfer occurs. In addition, taxable events are created when S corporations distribute profits to shareholders and when shareholders sell of liquidate their stock. Conversely, contributions to LLCs and distributions of appreciated LLC property can be tax-free to LLC members
3. Shareholders may not qualify to deduct S corporation losses from other income sources. Under Section 469 of the Internal Revenue Code, taxpayers who do not “materially participate” in an income-generating activity on a regular and continuous basis may not use the losses from those passive activities to reduce or offset non-passive income earned from wages, interest, dividends and capital gains. Rather, losses from passive activities, including rental activities by anyone other than a real estate professional, are deductible only against income related to those and other passive activities.
4. S corporation assets do not receive a step-up in tax basis upon the death of a shareholder. When shareholders in S corporations pass away or sell their interest to third parties, the beneficiaries (or buyers, in the case of a sale) receive a step-up in the basis of their inherited (or purchased) stock to the fair market value at the time of death (or time of sale). This readjustment in the value of appreciated assets is higher than the amount paid by the original owners, which, in turn, can minimize or even eliminate the heirs’ and/or buyers’ exposure to capital gains tax in the future. The problem is that the step-up does not apply to the S corporations’ underlying assets. This can result in heirs and/or buyers being subject to income tax on an S corporation’s earnings from before they took ownership of the stock, and it may reduce the availability of valuable depreciation and amortization deductions that would otherwise apply to real property.Conversely, entities structured as partnerships or LLCs have the flexibility to make Section 754 elections to step-up their underlying assets to the fair market value. This equalizes the new partners’ basis in the purchased partnership interest in property (outside basis) and their share of the basis of the assets inside the partnership net of liabilities (inside basis), which increases depreciation and amortization.
5. S corporations may not retain earnings tax-free. Instead, at the end of each year, S corporations, like partnerships and LLCs, must allocate all of their profits to shareholders who are responsible for paying taxes on those amounts regardless of whether or not they actually receive distributions. Conversely, C corporations can retain and pay taxes on their earnings without passing those obligations to their shareholders. In most cases, C corporations may do so at lower income tax rates.