The S corporation is a form of business structure thusly named because it is structured in such a way that it meets, and falls under the purview, of the IRS Revenue Code subchapter S. In many ways, it is very much like a traditional corporation, but with certain partnership-like traits that can benefit certain types of business organizations. One of the primary advantage of being treated as a chapter S Corporation is that of pass-through taxation. Pass-through taxation exists when the shareholders are taxed at the individual level, like a partnership, rather than first at the company level, then again at the individual level. This gives the shareholders the best of both worlds in many instances–the pass-through taxation benefits of a simple partnership, and the limited liability and asset protection that a corporation affords.
A standard (or “C”) corporation is taxed on it’s earnings as a company, then any dividends distributed to individual shareholders are again taxed at the individual rate (about 15% for Federal taxes). This is known as the double-taxation jeopardy and is one of the main reasons for the existence of the S Corporation.
The S Corporation, on the other hand, is not taxed at the company level. Instead, it is taxed based on the distributions to the shareholders at the individual shareholders’ marginal rate. One thing to bear in mind is that this taxation occurs whether or not there is an actual distribution to the shareholders. This means that the income is only taxed once, as a distribution to the share holders.
This pass-through taxation method can be both a boon and a nuisance. For example, let’s take an imaginary company named Wallaby, Inc. We’ll say there are three partners, John, Jack, and Jacob, with John owning 50%, Jack owning 25%, and Jacob the remaining 25%. Wallaby, Inc. earned $10 million last year as net income. At tax time, John will have to claim $5 million, Jack $2.5 million, and Jacob the remaining $2.5 million. If John, as the majority owner, decides not to distribute the net income profit, John, Jack and Jacob will still be liable for taxes on the earnings as if a distribution was made in that manner, even though none of the three received an actual cash distribution. This situation can be manipulated via what is termed a “squeeze play” by a majority partner (or partners in collusion) in an attempt to squeeze out a minority or undesirable partner.
In the traditional corporation, although there is the initial corporate tax, there is no dividend tax at the individual shareholder level unless an actual distribution is made.
Another limitation to the S Corporation is the fact that the number of shareholders is limited to 100, and if there is only one shareholder, there is the ever-present danger that the IRS disregards the chapter S status and treats the company as a standard corporation for tax purposes. This is more likely the case when there is any sort of deviation from the corporate formalities.
S Corporation Formalities
The forming of an organization as an S corporation also means that, just like with a traditional corporation, the corporate formalities must be observed. Corporate formalities are the actions that must be performed by a corporation’s director, officers, or shareholders in order to maintain the protection afforded by the formation of the corporation. These are essential procedures that serve to protect the personal assets of a Corporation’s directors, officers, and shareholders.
The Formalities can be summarized as follows:
- Corporate Funds must be maintained separate and apart from Personal Funds.
- There must be Annual Meetings of the Board of Directors.
- There must exist Corporate Minutes and an officer assigned to take and care for the minutes.
- All Corporate engagements, contracts, and strategic acquisitions must be in Written Form.
Much more in-depth discussion and descriptions of the corporate formalities can be found in our section containing a Corporate Formalities Checklist. Moreover, it bears mentioning that the adherence to the corporate formalities is a must for the successful operation of any corporation. These formalities serve to preserve the limited liability and tax benefits afforded by the corporate status.
Filing for Subchapter S Treatment
The steps necessary to achieve S corporation status are not terribly complicated, but need strict attention paid to them to ensure that the status withstands scrutiny and the benefits of the status are enjoyed.
To start, the shareholder(s) of an existing corporation, or the owner of a new corporation, must execute IRS Form 2553, along with any local documentation if the state of residence for the corporation recognizes S corporations (some states treat all corporations the same, and yet others allow for the S designation and follow similar taxation strategies). The execution and filing of this election must occur before the 16th day of the third month following the close of the corporation tax year in order for the corporation to be considered for S status during the current tax year. The corporation must meet the S Corporation qualifications during the aforementioned 2.5 months, and all shareholders must agree to the status, irrespective of whether or not they own stock at the time of the change in status.
Relinquishing S Election Status
S Corporation status can be relinquished voluntarily via the filing of the appropriate statement of termination. This type of revocation of status may only be made with the approval and consent of the majority shareholders. The complete process, and all necessary supporting information requirements, can be found in the IRS Regulations section 1.1362-6(a)(3) and in Instructions for IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
Involuntary revocation or termination of status can occur any time the Regulatory agencies, such as the IRS or the State Franchise Tax Board, proclaim a violation of the eligibility requirements, or to much greater detriment, any failure to observe the corporate formalities that brings to question the separate legal entity status of the corporation.
Who Should Organize as an S Corporation?
Partnerships, groups of investors, or even existing corporate shareholders looking for the dual benefits of enjoying limited liability and pass-through taxation should seriously consider the S Corporation status, provided that the rules for eligibility can be met and sustained. There are many benefits to be garnered from this form of organization, though this is a decision that should be made with the assistance of an informed expert in subchapter S Corporations.
An S Corporation (named as such because of it’s organization meeting the IRS requirements to be taxed under Subchapter S of the Internal Revenue Code) is a corporation for which the subchapter S taxation election has been made in order for it to be treated as a pass-through entity for tax purposes, much like a partnership whose income or losses “pass through” to the individual shareholders’ personal tax returns (in direct proportion to their investment or ownership in the company), while still providing the same protections for assets and from liabilities as a traditional corporation. The shareholders will pay personal income taxes based on the S corporation’s income, regardless of whether or not the income is actually distributed, but they will avoid the “double taxation” that is inherent to the traditional corporation (or “C” corporation).
The Major Difference between a traditional Corporation and an S Corporation
Because of its “pass through” taxation structure, the S corporation is not subject to taxes at the corporate level, and hence avoids the pitfalls of “double taxation” (in a standard or traditional corporation, business income is first taxed at the corporate level, then the distribution of the residual income to the individual shareholders is taxed again as personal “income”) that befalls C corporations.
Unlike C corporation dividends which are taxed at the federal rate of 15.00%, S corporation dividends (or more properly titled “Distributions”) are taxed at the shareholder’s marginal tax rate. However, the c corporation dividend is subject to the double-taxation mentioned above. The income is first taxed at the corporate level before it is distributed as a dividend and then taxed as income when issued to the individual shareholders.
For example, Cogs Inc, is formed as an S corporation, makes $20 million in net income and is owned 51% by Jack and 49% by Tom. On Jack’s personal tax return, he will report $10.2 million in income and Tom will report $9.8 million. If Jack (as the majority owner) decides not to distribute the net income profit, both Jack and Tom will still be liable for taxes on the earnings as if a distribution was made in that manner, even though neither received any cash distribution. This is an example of a corporate “squeeze-play” that can be used in an attempt to force out a minority partner.
Business Goals of an S Corporation
Having S corporation status provides for a few substantial benefits for a corporation. First and foremost, of course, is the goal of achieving limited liability, or mitigating the impact of personal law suits, or other forms of debt incurred by individual shareholders, against shareholders, and protecting against them impacting the corporation as a whole, or the rest of the shareholders as individuals. This asset protection benefit is true of both the traditional corporation and the S corporation. More specific to the selection of an S corporation is the pass-through taxation benefit. While there are limitations as to the amount of shareholders that a corporation can have in order to meet the IRS requirements for S corporation status, most corporations that fit the size threshold (in most cases, not more than 75 to 100 shareholders) elect to be taxed as an S corporation because it allows the individual shareholders to earn a larger distribution of the business income. The corporation can pass income directly to shareholders and avoid the double taxation that is inherent with the dividends of public companies, while still enjoying the advantages of the corporate structure.
Electing S Corporation Status
Electing S corporation status has tax liability implications. S status allows shareholders to apply company profits and losses to individual income tax returns. In order to elect S status, one must first incorporate as a general C corporation and then file IRS form 2553. If you have recently incorporated, your corporation may file for S status anytime during the tax year within 75 days of your incorporation date. Otherwise, this action must be taken by March 15 if the corporation is a calendar year taxpayer, in order for the election to take effect for the current tax year. A corporation may later decide to elect S corporation status, but this decision would not take effect until the following year.
Passive Income Caution
Passive income is any income generated by an investment; i.e. stocks, bonds, equity-type investments, real estate, etc. Active income is generated by services rendered, products sold, etc. It is important to make sure that your S corporation’s passive income does not exceed 25% of the corporation’s gross receipts over a consecutive three year period; otherwise your corporation would be in danger of having its S status revoked by the IRS. A better choice if your business is expected to have substantial passive income may be an LLC.
Qualifying for S Corporation Status
In order to qualify for S corporation status a few requisite measures must be met. 1. The corporation must be formed as a general, for-profit C class corporation. 2. Be sure that your corporation has only issued one class of stock. 3. All the shareholders are U.S. Citizens or Permanent Residents. 4. There can be no more than 75 shareholders. 5. Your corporation’s passive income level does not pass the 25% of gross receipts limit. 6. If your corporation has a tax-year end date other than December 31, you must file for permission from the IRS. If your corporation has met all the above, you may file form 2553 with the IRS to elect S status.
S Corporation vs. LLC
A Limited Liability Company can be owned (have as “members”) corporations, other LLC’s, partnerships, trusts and non-US citizen, non-resident aliens. The S corporation, on the other hand, can only be owned by individual US citizens or permanent resident aliens. An LLC may offer different levels/classes of membership while an S corporation may only offer one class of stock. An LLC may have any number of members but an S corporation is limited to a maximum of 75 to 100 shareholders (depending on the rules of the state in which it is formed). When a shareholder of an S corporation is sued in a personal (not a business) lawsuit, the shares of stock are an asset that may be seized. When a member of an LLC is sued in a personal (not a business) lawsuit, there are provisions to protect the membership stake from being taken from the individual.
Legal Issues to Consider with an S Corporation
To be sure, there are certain regulatory steps and requirements that need to be met before a corporation can be treated as an S corporation. First, the shareholders of an existing corporation (or the originator of a new corporation) must make an election to be an S corporation on IRS Form 2553 (and the corresponding form for the state in which the corporation was incorporated) before the 16th day of the third month following the close of the C corporation tax year if the election is to be effective for the current tax year. The C corporation must qualify as an eligible corporation during those 2 1/2 months and all shareholders during those 2 1/2 months must consent, even if they do not own stock at the time of the election. If the election is filed after the 15th day of the third month of the tax year, the election will be in effect for the next tax year and all shareholders at the time of the election must consent.
Termination of S Corporation Status
Voluntary termination of an S election is made by filing a statement with the Service Center where the original election was properly filed. A revocation may be made only with the consent of shareholders who, at the time the revocation is made, hold more than one-half of the number of issued and outstanding shares of stock (including nonvoting stock) of the corporation. There is specific information that must be included in the statement and this information is outlined in Regulations section 1.1362-6(a)(3) and in Instructions for IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
The revocation may state an effective date as long as it is on or after the date the revocation is filed. If no date is specified and the revocation is filed before the 15th day of the third month of the tax year, the revocation will be effective for the current tax year. If the revocation is filed after the 15th day of the third month of the tax year, the revocation will be effective for the next tax year.
Should I Organize My Enterprise as an S Corporation?
If you intend for your corporation to have more than a few shareholders (but less than the limit in your individual state) and you can appreciate the benefits of pass-through taxation while at the same time understanding the potential pitfalls involved with the “taxation irrespective of distribution,” and you meet the legal requirements outlined above, then the S corporation can go a long way towards making your business profitable and attractive to the right investors.