An S corporation is type of business entity that functions like a corporation, but is taxed like a partnership. All of the corporate income, losses, deductions, and taxes are paid by the shareholders, rather than by the corporation itself. When creating an S corporation, which is an option for corporations with fewer than 100 shareholders, the owner must charter the business as a corporation in the state where it is established. To explore this concept, consider the following S corporation definition.
Definition of S Corporation
- An ordinary business corporation created through an IRS tax election. The corporation passes its income, deductions, credits, and losses through the shareholders.
What is an S Corporation
An S corporation is a corporation that chooses to pass its income, deductions, credits, and losses through its shareholders, for the purpose of federal taxes. The shareholders are required to report their income and losses on their personal tax returns, where they are assessed at an individual income tax rate. When this occurs, the corporation’s income is not taxed at both the corporate level and the shareholder income level.
Example of S Corporation Taxation
Jacks, Inc. is formed as an S corporation in the state of Florida. Robert owns 51% of the corporation, and Brenda owns 49%. In 2015, the company’s net profits totaled $20 million. When filing their personal tax returns, Robert will report $10.2 million in income, and Brenda will report $9.8 million.
The corporation can choose not to distribute the company’s proceeds, in favor of putting the money back into the business. In this example of S Corporation taxation, the shareholders will still be taxed on their portion of the profits, however.
Eligibility Criteria for an S Corporation
The option to form as an S Corporation is not available to any corporation. Rather, there are certain eligibility criteria which must be met in order to elect the S Corporation status via the IRS. The business must:
- Be a domestic corporation
- Have no more than 100 shareholders
- Include only allowable shareholders
- Have only one class of stock
- Not be an ineligible corporation
If any of these conditions are not met, or if they change at any time, the S corporation risks being treated as a different type of corporation.
Pros and Cons of an S Corporation
There are many ways in which a business can be chartered, each of which depends on how the business is to function, who will be in charge of its operations, and how the profits are to be paid out. The pros and cons of an S Corporation lie mainly in how it is taxed, and protection of the shareholders. The cons are generally based in the requirements of corporate records.
The pros of an S Corporation include:
- No Double Taxation – an S corporation does not pay income taxes, but pays its profits to the shareholders, who are then taxed on their personal returns.
- Shareholder Protection from Liability – the personal assets of the shareholders are separate from the business assets, which protects them from judgements against the business.
- Ability to take on More Investors – S corporations can have as many as 100 shareholders.
- Simpler Accounting Methods – an S corporation with no inventory can use the cash method of accounting, which is simpler than the accrual method.
- Business Expense Write–Off – many expenses paid by the shareholders of an S corporation can be counted as business expenses. This may include health and other types of insurance, depending on which shareholders are considered employees. It is important to consult with a professional accountant or tax professional on this issue.
The cons of an S Corporation include:
- Recognition of Business Type – some states do not recognize S corporations.
- Rules and Fees – S corporations are required to file federal and state documents, just like any other corporation, such as Articles of Incorporation, and corporate minutes. They must also hold regular shareholder meetings, and pay certain fees.
- Taxation of Shareholders – while C corporation shareholders pay personal income taxes only on dividends they actually receive, S corporation shareholders pay personal income taxes on the company’s total income, even if no payout was received.
- Limited Stock Class – S corporations may issue only one class of stock.
- IRS Salary Requirements – all owners and officers of an S corporation are required to be paid a “reasonable” salary, even if the company is not yet profitable. A “reasonable” salary is what any individual with skills appropriate for the position would be paid on the open job market.
Forming an S Corporation
When an individual, or group of individuals, wishes to form an S corporation, it must first be determined whether the business qualifies under the rules of the Internal Revenue Service (“IRS”). The “S” classification of a corporation is a tax election made with the IRS. So, the first step in forming such a company is to register the business as a corporation by filing the Articles of Incorporation, and other required documents, with the Secretary of State, in the state in which the corporation resides. The business must then obtain all of the necessary business licenses and permits through the state and city.
Once the corporation has been fully established through the state, the election must be made with the IRS by filing form is Form 2553. Complete instructions for forming an S corporation are available on the IRS website. Additional information on starting and managing a new business can be found on the U.S. Small Business Association’s (“SBA”) website.
If the new corporation will be hiring employees, the owners should brush up on federal and state regulations regarding employees. This information can be found on the U.S. Department of Labor’s website. Additionally, the SBA offers online training for employers through a video series.
Difference Between S Corporation, C Corporation, and LLC
In making the important decision regarding the type of business entity to register a new company, there are a number of facts to consider, and decisions to be made. Each type of business has specific characteristics designed to benefit owners, partners, and shareholders.
An LLC (Limited Liability Company) is a business type that combines the limited liability protection of a corporation, with the pass-through taxation of a partnership. Understanding the difference between S corporations, C corporations, and LLCs is the first step to making the best decision.
|Entity Type||S Corporation||C Corporation||LLC|
|Overview||Operates like a partnership, profits and losses pass through to the shareholders||A separate entity that is taxed directly on profits/ losses, while protecting the shareholders’ assets from creditor claims||A hybrid business type that gives the members liability protection similar to a corporation|
|Shareholder/Member Liability||Shareholders not liable||Shareholders not liable||Members not typically held liable|
|Election of board of directors, officers, annual meetings and filing||Election of board of directors, officers, annual meetings and filing||Relatively few requirements|
|Management||Directors elected to manage operations of the business||Directors elected to manage operations of the business||
Structure set up however the members prefer
|Term/Termination||Extends after death or withdrawal of shareholders||Extends after death or withdrawal of shareholders||Perpetual, unless state requires fixed amount of time|
income passed through members, who are taxed
|Double taxation, as corporation itself is taxed, then shareholders are taxed on personal income.||
|Limit of Shareholders or Partners||Maximum of 100||No limit||No limit|
Termination of an S Corporation
Voluntary termination of an S corporation is done by filing a statement with the Secretary of State, or other service center, where the corporation was established. The state office will have specific instructions for who is permitted to terminate the S corporation, and which forms need to be submitted. Once the corporation has been terminated through the Secretary of State, certain information must be provided to the IRS. The IRS provides helpful information on terminating a business.
Inadvertent Termination of an S Corporation
The requirements for starting and maintaining an S corporation may be confusing, making them difficult to stay in compliance. Failing to adhere to the requirements may result in an “inadvertent termination” of the S corporation status. Because of the large number of inadvertent terminations, the IRS has made it easier to cure the default. Information regarding curing an inadvertent termination of an S corporation, talk to a tax professional, or contact the IRS.
S Corporation Avoiding Payroll Tax
S corporations are frequently used as a vehicle to avoid employment taxes, and the IRS has begun aggressively identifying and penalizing people using it. David Watson, a CPA, registered an S corporation called DEWPC, of which he was the sole shareholder. Watson maintained a 25% share in another accounting firm called LWBJ.
During the years 2002 and 2003, Watson worked 35-40 hours per week, under the name DEWPC, providing tax services to LWBJ clients, paying himself wages in the amount of $24,000 per year. Watson did receive annual shareholder distributions from DEWPC in the amount of $203,651, and $175,470. In doing this, Watson avoided paying employment taxes on the true value of his services, while maximizing the amount he received as a shareholder in each company.
An IRS examiner noticed that Watson’s salary did not rise to the level of his expertise. In other words, he was not being paid a salary well below what someone with the same experience would normally receive. An expert employed by the IRS determined that a firm the size of DEWPC would see around $70,000 in revenue each year, and that Watson should have received 33% of that compensation.
The IRS took the issue of underpayment for the purpose of avoiding taxes to the District Court, which ruled in favor of the tax authority. It agreed that Watson should have received about $91,000 per year, and reclassified over $67,000 of Watson’s shareholder distributions as salary, and held DEWPC liable for payroll taxes on that amount.
Related Legal Terms and Issues
- Judgment – A formal decision made by a court in a lawsuit.
- Partnership – A business owned by two or more partners.
- Shareholder – Someone who owns shares in a company. A shareholder, also referred to as a “stockholder,” profits when the company makes money, but also loses money when the company is unsuccessful.