Key Insight
S-corp status determines how the seller is taxed on the sale and what elections are available. Buyers of S-corps have access to deal structures (like the 338(h)(10) election) that aren't available for other entity types.
What Makes an S-Corp
An S-corporation is a C-corporation that has elected pass-through tax treatment under Subchapter S of the Internal Revenue Code. Key characteristics:
- No federal corporate income tax at the entity level
- Profits and losses flow to shareholders' personal returns
- Limited to 100 shareholders, all of whom must be US citizens or resident aliens
- Only one class of stock permitted
- Must be a domestic corporation
S-Corp vs. LLC for Acquisitions
Both S-corps and LLCs are common structures for acquired businesses, but they differ in flexibility and tax treatment:
- S-corps have more rigid ownership and compensation rules; owners who work in the business must take a "reasonable salary" subject to payroll taxes
- LLCs are more flexible in ownership and profit distribution; may elect to be taxed as an S-corp
The Reasonable Compensation Requirement
S-corp owners who work in the business must pay themselves a "reasonable salary" — the IRS requires that W-2 compensation for working shareholders reflects fair market value for their labor. Underpaying on salary to avoid payroll taxes is an audit risk. This affects the add-back calculation: only compensation above market rate should be added back in the SDE calculation.
Sale of S-Corp Stock
When an S-corp is sold as a stock sale, gains are generally treated as long-term capital gains. The 338(h)(10) election allows the parties to treat the stock sale as an asset sale for tax purposes — with the buyer receiving a stepped-up basis while the stock sale structure is preserved operationally.
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