S corporations are popular among small business owners because they provide substantial liability protection for shareholders, allow them to avoid the double taxation problem presented by C corporations, and allow shareholders to take some profits in the form of dividends, which helps limit self employment tax liability. Proper accounting is paramount for corporations, however, and especially for S corporations, because of the requirement that all shares be treated equally with regard to distribution of dividends. An accounting error that results in an unequal distribution could result in the S corporation status being disallowed by the IRS, leading to significant potential tax consequences.
As you keep track of and allocate the equity put in by shareholders as well as the earnings generated by the corporation itself, you will typically need a minimum of five separate headings within the shareholders equity section of your books: common or preferred stock issued, paid-in capital, dividends paid and earnings retained by the company, either for payment as future dividends or retained for planned investment or reserves.
You will need to have one account per shareholder, at a minimum, in "paid-in" capital, as well as "dividends paid." You will also need to track how many shares of common or preferred stock each shareholder owns. (As a practical matter, an S corporation will not issue preferred stock, since it would violate the rule requiring S corporations to issue only one class of stock. The preferred stock entry would only apply to C corporations.)
Treatment of Sweat Equity
The treatment of sweat equity in S corporations is problematic, because there is no way to issue extra dividends to the individual working in the company to build up sweat equity. In an S corporation, this can be arranged through a salary, plus the gradual transfer of shares to the individual providing the labor in exchange for an ownership interest. From an accounting perspective, this would require an additional entry in the books, tracking the hours or other contributions put in by the sweat equity shareholder, pending the transfer of shares to compensate. Meanwhile, the sweat equity shareholder must draw a salary, subject to income and Social Security taxes.
In addition to the restriction on multiple share classes, S corporations can have no more than 100 shareholders. These shareholders must be U.S. entities, and cannot be other corporations. Only individuals and certain kinds of trusts can hold shares in S corporations. Sometimes these restrictions impede the business's ability to recruit capital and expertise through issuing shares. In this case, the owners may consider converting to a limited liability company or a C corporation.