Can an S Corporation Invest Money in Stocks or Mutual Funds?

An S corporation is a special form of corporation that doesn't face the double taxation of other corporations, for which profits are taxed once at the corporate level and then again when profits are distributed to shareholders. In an S corporation, profits flow without taxation from the corporation to the shareholder, who pays income taxes on them according to the usual individual income or capital gains tax rates. An S corporation normally can invest in stocks or mutual funds.

If you buy a stock as an individual investor and sell it at a profit before owning it for a year, you'll pay taxes on the profits according to the IRS schedule for individual tax filings. For example, if you're single in 2013 and earning less than $87,500 of taxable income, your tax rate is 25 percent. If, instead you hold the stock for a year, then sell it, you'll pay taxes on it according to the applicable capital gains tax rate. If you're in the 25 percent ordinary income tax bracket, your capital gains tax rate on the stock sale is 15 percent.

An S corporation can buy stock. There's no prohibition against any purchase by an S corporation that you can make as an individual. You may wonder, since there's no tax at the corporate level in an S corporation, if you can sell the stock in the corporation and defer taxes on it for as long as you hold it in the corporation. Unfortunately, you can't. The moment you sell the stock, the profit on the sale either flows out of the S corporation to you and becomes taxable income, or -- if retained -- triggers the IRS's termination of S corporation status, in which case the profit flows out to you and again becomes taxable income.

Ordinarily, purchases and sales of stock by an S corporation have the same tax implications as purchases and sales of stock by an individual. There is one possible exception: If you form an S corporation and its primary business is stock trading, then, as noted in IRS Publication 550, the S corporation is exempt from the IRS's passive investment limitations for an individual who is not a full-time stock trader.

Note, however, that the IRS may disallow tax benefits when tax avoidance is the principal purpose of any action, including forming an S corporation to trade stocks. If you form an S corporation for trading purposes, you must have a good reason for doing it that doesn't have to do with tax avoidance.