S Corporation Operational Limitations

by Chris Hamilton

Although S-corporation status allows for tax treatment that can greatly reduce taxes for owners and shareholders of the company, there are limitations when it expands its operations. S-corporation owners can switch to C-corporation status if corporate structure prevents them from obtaining sufficient capital or allows them fewer tax benefits.


Corporations frequently expand their operations by acquiring other companies and treating them as subsidiaries. S-corporations can only treat acquisitions as subsidiaries, formally called qualified subchapter S subsidiaries. To qualify, an S-corporation must acquire 100 percent of a domestic company to treat it as a subsidiary. They cannot acquire a financial institution or insurance company under Section 1361(b)(3)(B) of the Internal Revenue Code. These restrictions can seriously limit the scope of S-corporation operations. For example, a car dealership that purchases a small finance company must treat the business as a separate entity, triggering tax consequences and hindering the integration of business operations.


S-corporations that want to extend their business into new market niches face limits. They cannot offer banking services or insurance plans. If a C-corporation wants to focus its operations on purchasing products from manufacturers and resellers and selling them on the export market, it can attain domestic international sales corporation (DISC) status to receive preferential treatment. S-corporations are not eligible for DISC status.


Corporations expand their operations by investing profits or generating new capital through stock issues. An S-corporation cannot exceed 100 shareholders as of 2011. The owner of an S-corporation, married couples and family members count as a single shareholder. S-corporations with growing operational expenses must sell shares to the same investors or convert to a C-corporation to raise additional capital. S-corporations cannot sell shares to C-corporations. In addition, they cannot easily attract foreign investment, because non-residents aliens may not own shares in this type of entity.


Most corporations offer both preferred and common stock to protect their capital investments. Preferred stock typically offers investors fixed dividends but limited terms of sale. Common stock allows investors to sell at any time with few restrictions. In addition, corporations can offer different classes of preferred and common stocks to certain investors to attract capital. S-corporations can only issue one class of stock, limiting their ability to attract capital investment. Because this stock carries equal voting rights and privileges, a prominent shareholder can veto S-corporation plans, and the corporation cannot dilute the shareholder’s influence.

About the Author

Chris Hamilton has been a writer since 2005, specializing in business and legal topics. He contributes to various websites and holds a Bachelor of Science in biology from Virginia Tech.

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