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 – S Corporation vs. C 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!