An S corporation is a special type of corporation that is treated as a small corporation by the Internal Revenue Service (IRS) for federal income tax purposes. The tax structure that the IRS applies to an S corporation is what is used for partnerships. Federal taxes on business income is paid by individual owners, rather than by the business itself as an independent entity. The way income passes through to shareholders makes preferred stock, which gives a certain subset of shareholders special rights to corporate distributions, a problem for tax purposes in the S corporation context.
An S corporation is formed by filing articles of incorporation with a state agency, just like a regular corporation. State incorporation statutes allow corporations to implement a capitalization structure that represents how the initial shareholders want the corporation to be managed going forward. This means a corporation ordinarily has the discretion to issue stock with different voting and dividend rights attached, usually referred to as common stock versus preferred stock. A regular corporation that chooses to be taxed under Subchapter S of the Internal Revenue Code, however, receives special tax benefits in exchange for limiting its rights in this respect.
Subchapter S requires a corporation to comply with certain restrictions before it can make the election to be taxed under the section. One of the restrictions pertains to the capital structure of the corporation. An S corporation can only have one class of stock, with shareholders that have equal rights to distributions and to vote. An S corporation cannot sell preferred stock because the definition of such stock is that it grants shareholders preferential distribution of dividends and special voting rights.
An S corporation is taxed as a pass-through entity. Consequently. it does not have to pay income taxes on its profits and losses. Instead, those amounts are passed through to shareholders and recorded on their individual income tax returns. The amount of profit or loss allocated to each shareholder is directly proportional to the percentage of the outstanding shares of stock he owns. Subchapter S does not allow a shareholder to take more or less of the tax obligation than is indicated by his percentage of ownership. Preferred stock is not allowed in an S corporation because the issuance of such stock would result in exactly that type of uneven distribution of profits and losses, which would make tracking tax liability more difficult for the IRS.
The restrictions imposed by Subchapter S are absolute. If an S corporation sells preferred stock at any time after the election is awarded, the act automatically cancels the election. From that point forward, the S corporation is taxed as a regular C corporation and loses its pass-through entity tax benefits. The corporation would have to cancel the preferred stock and return to a single stock capital structure before it could re-apply for S corporation status.