Subchapter S: An Alternative Tax Status for Corporations
The Subchapter S (S-Corp) tax status offers small businesses and LLC owners the benefit of avoiding double taxation and treating LLC owners as W-2 employees. For cooperatives qualifying for Subchapter S, this means sharing company taxes with members, potentially reducing overall tax burdens and simplifying profit distribution.
Understanding Subchapter S Tax Status: Benefits for Small Businesses and LLC Owners
Subchapter S (S-Corp) tax status is a popular choice for many small businesses because it helps them avoid being taxed twice and allows them to pass on their gains and losses to the shareholders. It’s especially useful for LLC owners who want to be treated as W-2 employees instead of self-employed partners, while still enjoying the benefits of pass-through taxation. In an S-Corp, the owners are considered employees, the entity itself usually doesn’t pay corporate income tax, and the owners are taxed on profit distributions as regular income rather than self-employment income like Subchapter K. However, Subchapter S tax status can have drawbacks for cooperatives, such as restrictions on maintaining unallocated reserve accounts and specific profit distribution requirements based on shareholder capital investment.
Why might a cooperative choose Subchapter S?
This tax status is not usually recommended for cooperatives because it limits profit-sharing based on individual contributions, unless the members have equal ownership stakes. However, in a small cooperative where everyone plans to invest and work equally, it could be beneficial, especially if the IRS considers patronage dividends as self-employment income. Another situation where it can be useful is when an existing S-Corp business transitions to worker ownership. Keeping the S-Corp status might be easier and cause fewer tax issues for the original owner compared to converting to Subchapter T.
Who is Eligible?
The following S-Corp restrictions may rule out this tax status for some cooperatives:
- S-Corp owners can only be individuals and certain trusts and estates; other legal entities cannot be members.
- It cannot have members who are “nonresident aliens.”
- It cannot have more than 100 shareholders total.
- It can only have one class of stock, meaning that the cooperative cannot have a class of preferred shares. All members and investors must have the same distribution and liquidation rights (however, voting rights can differ). A cooperative that has converted from another entity type using seller financing could inadvertently create a second class of stock under IRS rules.
Drawbacks of Subchapter S
Subchapter S has the same drawbacks in the context of a cooperative as Subchapter K; primarily, that the entity cannot have an unallocated reserve account. But S-Corps are subject to a number of additional restrictions that make this tax status unworkable for cooperatives in most cases.
The primary difficulty with S-Corp status is that the entity must distribute profits on the basis of a shareholder’s capital investment. Cooperatives, in contrast, are intended to subordinate capital, and to share profits on the basis of member patronage, not their financial investment. Unless members’ patronage is at all times in proportion to their ownership stake in the cooperative, an S-Corp cannot share profits on a cooperative basis. Where this can work is when a cooperative has equal buy-in amounts for all members and all members also work the same number of hours. But since this is often not the case, Subchapter S is often not appropriate for a cooperative.
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