All corporations begin their lives as C corporations by default, but after formation, may elect Subchapter S status by filing IRS form 2553. An S corporation gets its name from Subchapter S of Chapter 1 of the Internal Revenue Code which defines the rules for S corporations. Unlike a C corporation, an S corporation is treated by the IRS as a partnership or a sole proprietorship for taxation purposes.
This treatment, allows the business to pass corporate income, losses, deductions and credits through to the shareholders’ personal federal income tax returns, rather than be taxed at the corporate level. This means that profits are only taxed once by the federal government and not as corporate income and then again as personal income when it is passed on to shareholders. Shareholder-employees receive a salary that when paid, should include both the employer and employee deduction for FICA. Profits paid in the form of dividends are not subject to self-employment tax or social security, and thereby creating a tendency for shareholder-employees to choose a lower salary and a higher profit distribution. Accordingly, the IRS closely examines S corporations to ensure that they are paying fair and reasonable salaries based on industry standards.
The qualifications for an S corporation are as follows:
The business must have become an organized corporation prior to filing for S corporation status. A corporation must file a Form 2553 electing Subchapter S status by the fifteenth day of the third month of the corporation's tax year. The form must be signed by all shareholders. An S corporation must be a domestic corporation and can have no more than 100 shareholders. All shareholders must be citizens or residents of the United States. Certain financial institutions, insurance companies and domestic international sales corporations are not eligible to be shareholders of an S corporation. Estates and trusts may be shareholders, but no corporations (with the exception of certain non-profit corporations), partnerships, sole proprietorships, or foreign investors are permitted as shareholders. The business must issue only one class of stock although voting rights may differ. C Corporations that have been S corporations within the last five years are not eligible.
The advantages of an S corporation are:
· Shareholders are protected from personal liability for the debts incurred by the corporation similarly to a C corporation. Shareholders can only be held accountable up to the amount of their capital investment in the business.
· If an S corporation has financial troubles or faced with judgments, only the entity’s assets may be seized.
· In all respects an S corporation is a considered to be a separate entity apart from its shareholders for all purposes except taxation. However, an S corporation is NOT considered a separate taxable entity so its shareholders are relieved of the double taxation that occurs with C corporations that face taxation on corporate profits and then shareholders are taxed personally on income that flows to them in the form of dividends.
· Professional corporations are permitted to elect S status.
The disadvantages of an S corporation are:
Health and accident insurance premiums for shareholder-employees holding a 2% or higher interest of company stock cannot be deducted as business expenses for tax purposes. Furthermore, these shareholder-employees must be taxed on these benefits. Like any other corporation, an S corporation must fulfill all of the recordkeeping requirements of a traditional corporation, such as regular shareholder and directors’ meetings, updated minutes and resolutions, and maintaining separate personal and corporate accounts. If an S corporation acquires a foreign investor, the corporation’s status as an S corporation will be revoked and it will return to a C corporation.
An S corporation combines the best characteristics of being a sole proprietor and a C corporation. An S corporation is a separate legal entity that can be owned by a single person, affords limited liability protection to its owners for the debts and liabilities of the business, and provides the same control over the day to day operations of the business as a sole proprietorship. Although a real corporation in every sense of the word, the S election allows the profits and losses of the business to flow through to the income tax returns of its owners, thereby eliminating a corporate business tax.