Many small businesses and start-up entrepreneurs consider using the S corporation as the entity of choice for running their business. The formation, management, and functioning of an S corporation is the same as, or very similar to, the formation of a C corporation. The primary difference between the S corporation and its sibling, the C corporation, is the way in which the shareholders elect to have the income of the corporation taxed.
Rather than having the income of the corporation taxed at the corporate level, all of the income of the S corporation "flows through" to the shareholders of the corporation and is then taxed at the shareholder level on their individual income tax returns. However, a C corporation cannot just automatically decide to become an S corporation. Just as a candidate for an elective office must "tow the line" in order to gain the winning number of votes, the shareholders of the S corporation must adhere to the rules prescribed by the Internal Revenue Code and the Treasury Regulations in order to elect and maintain the S corporation status.
An S corporation is a corporation, or an organization that has elected to be treated as a corporation for tax purposes, that (i) is eligible to elect S corporation status and (ii) whose shareholders have all consented in writing to have the corporation elect S corporation status.
Generally, an S corporation is incorporated, just like a C corporation, by filing Articles of Incorporation with the Secretary of State, pursuant to the state's incorporation statutes. Once the corporation has been formed under state law, and if the corporation is eligible to elect S corporation status, the shareholders of the corporation may elect to have the corporation treated as an S corporation for the purposes of federal income taxation.
In order to elect S corporation status, a corporation must satisfy the following requirements:
For the purposes of S corporation status, a husband and wife who are both shareholders in the corporation will be treated as a single shareholder. However, if the husband and wife subsequently divorce with both of them still owning separate shareholder interests in the corporation, the divorce will result in two separate shareholders for purposes of the 100-shareholder limitation.
A resident alien (e.g. a non-U.S. citizen residing in the United States) may be a shareholder in an S corporation. However, a corporation that has a non-resident alien as a shareholder may not qualify for S corporation status.
A qualifying S corporation may not have more than one class of stock issued and outstanding. The outstanding shares must be identical in regards to the rights of the shareholders to share in the profits and assets of the corporation. In other words, each share of stock must confer identical rights with respect to the shareholder's right to receive dividends and distribution of remaining assets upon the liquidation of the corporation.
The best example of different classes of stock is common stock and preferred stock. Generally, ownership of a share of preferred stock grants the shareholder the right to receive distributions of dividends prior to any distribution of dividends to common shareholders, and upon liquidation of the corporation, to receive a return of the preferred shareholder's capital investment prior to any distribution of remaining corporation assets to the common shareholders. Because the preferred shareholders possess different profit-sharing and liquidation rights than the common shareholders, the preferred shareholders are a separate class of stock.
For example, what if the shareholders agree to different voting rights? Differences in voting rights between various shares of stock are permitted and will not disqualify a corporation for S corporation status. Examples of different voting rights would include disproportionate voting, cumulative voting, and restrictions on a shareholder's right to vote on corporate matters.
Buy-sell agreements and redemption agreements that restrict a withdrawing shareholder's ability to transfer his or her stock, or obligate the withdrawing shareholder to sell his or her stock to either the corporation or the remaining shareholders for a set price, are generally disregarded in determining whether the corporation has a single class of stock.
The election of S corporation status is made on Form 2553, "Election by a Small Business Corporation" and filed with the IRS Service Center where the corporation files its corporate federal income tax return. The election of the S corporation status must be unanimously approved by all of the shareholders, as evidenced by having all of the shareholders sign the Form 2553. If a shareholder lives in a community property state, the shareholder and the shareholder's spouse must both sign the Form 2553, even if the shareholder's spouse does not own any ownership interest in the corporation.
The Form 2553 must be filed on or before the 15th day of the 3rd month of the corporation's tax year in order for the election to be effective as of the beginning of that tax year. A corporation that is on a calendar tax year must file the Form 2553 on or before March 15th in order for the election to be effective for that tax year.
In a C corporation, all income, deductions, gains, and losses of the corporation are accumulated at the corporate level. The C corporation must then pay federal income tax on the C corporation's net income and gains, leaving an amount referred to as "net income after taxes". If the C corporation makes dividend distributions to its shareholders, each shareholder must report the amount of dividends received on his or her individual tax return, and such dividend income will be taxed once more at the shareholder level. Since the net income and gains of the C corporation are reduced by taxes at both at the corporate level and at the shareholder level, C corporations are subjected to what is commonly referred to as "double taxation".
In contrast, the tax reporting of an S corporation is similar to the tax reporting of a partnership. An S corporation does not pay income tax at the corporate level. Instead, all of the income, deductions, gains and losses of an S corporation are divided among, and passed through to, the shareholders of the S corporation. Each shareholder is allocated a portion of each item of income, deduction, gain and loss in accordance with such shareholder's respective ownership interest in the corporation. Each shareholder must then report their allocated share of the corporate income and deductions on their own individual income tax returns. Because there is no taxation at the corporate level, the net income and gains of the S corporation are taxed only once, at the shareholder level.
corporation must file an annual information return on Form 1120S. The S corporation reports all items of corporate income, deductions, gains, and losses on the Form 1120S. The form is due on or before the 15th day of the 3rd month following the close of the corporation's tax year. An S corporation with a January 1 thru December 31 tax year will need to file its Form 1120S on or before March 15th of the succeeding calendar year.
In addition, the S corporation must also provide each shareholder with a Schedule K-1. The Schedule K-1 allocates to each individual shareholder his or her share of all items of corporation income, deduction, gain and loss, based upon the shareholder's ownership interest in the corporation. The deadline for providing Schedule K-1s to the shareholders coincides with the filing deadline for the Form 1120S.
S corporation status can be terminated either voluntarily or involuntarily. A corporation's S corporation status is involuntarily terminated if any event occurs that would prohibit the corporation from making the election in the first place (a "disqualifying event"). Examples of a disqualifying event would include having more than 75 shareholders, a shareholder that is other than an individual, estate, or trust, or a shareholder who is a non-resident alien. Generally, the election is automatically terminated as of the date on which the disqualifying event occurs. However, if a corporation has both accumulated earnings and profits as well as passive investment income that exceeds 25 percent of the corporation's gross receipts for three consecutive years, the corporation'S corporation election will be terminated beginning with the following tax year.
An S corporation election may be voluntarily revoked with the consent of shareholders holding more than 50 percent of the outstanding shares of stock (voting and nonvoting) on the day the revocation is made. As part of the voluntary revocation, the shareholders may designate a prospective effective date. If no date is specified, a revocation which is made on or before the 15th day of the 3rd month of a corporation's tax year will be effective retroactive to the first day of the tax year. Any revocation made after the 15th day of the 3rd month of the corporation's tax year will be effective on the first day of the following tax year.
In general, a corporation may not re-elect S corporation status until the 5th year after the year in which the termination or revocation became effective. Exceptions may be made with the written consent of the Internal Revenue Service. If a corporation's S election is inadvertently terminated or inadvertently invalid when made, and the corporation makes a timely correction, the IRS can issue a written consent to waive the termination or permit the election. In such a case, the corporation must correct any condition that barred the corporation from qualifying as an S corporation and must obtain any required shareholder consents. In addition, all shareholders must agree in writing to make any adjustments that may be required by the IRS.
In addition to these income taxes, the proprietor also pays a 15.3% self-employment tax on the $90,000 of business profits. Roughly, this self-employment tax (which is equivalent to Social security and Medicare tax) equals $13,000.
Things usually work differently for the S corporation, however. To make calculations easy, assume the S corporation is owned by a single shareholder. In this case, the S corporation must break the $90,000 of profit into two buckets: wages and the leftover (which is called a distributive share). If the wages equal $40,000 and the leftover distributive share equals $50,000, the business pays Social Security and Medicare taxes (equivalent to self-employment tax) equal to roughly $6,000.
In this case, even though the two businesses make the exact same amount of money, the S corporation pays roughly $7,000 less in tax each year.
By the way, in addition to the big benefit of self-employment tax reduction, S Corporations also provide two other useful benefits--benefits which are a little more difficult to quantify but still important nonetheless.
One such benefit is that S corporation losses (such as those that often occur in the early startup years) can be used as tax deductions on the shareholders personal income tax returns.
Another such benefit is that the S corporation isn't taxed on S corporation profits--at least by the federal government.
Please contact me If you're interested in exploring the tax benefits of an S corporation
S corporations, or Sub-chapter S corporations, produce several tax benefits as compared to sole proprietorship, partnerships, and C corporations.
The big benefit--and the one that people usually talk about--is the payroll tax savings. To understand how this works, let me compare two alternatives: A sole proprietor making $90,000 a year and an S Corporation making $90,000 a year.
Of course, the taxes that a sole proprietor pays depends on his or her filing status, itemized deductions and family size, but typically such a person might pay about $12,000 in federal income taxes. The person might also pay another chunk in state income taxes.