Incorporation 101: What is S-Corporation?

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What is an S-Corporation?

S-Corporation is a regular corporation that has 100 shareholders or less and that passes-through net income or losses to its shareholders for tax purposes (similar to sole proprietorship or partnership). Since all corporate income is "passed through" directly to the shareholders who include the income on their individual tax returns, S Corporation are not subject to double taxation.

An eligible domestic corporation (C-Corporation) can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S-Corporation. Generally, an S Corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S-Corporation's shareholders include their share of the corporation's income or loss.

S-Corporation vs. C-Corporation

• Like C-Corporations, S-Corporations are separate legal entities from their shareholders and, under state laws, generally provide their shareholders with the same liability protection afforded to the shareholders of C corporations.

• Unlike C-Corporations, for Federal income tax purposes taxation of S corporations resembles that of partnerships. Thus, income is taxed at the shareholder level and not at the corporate level.

• Certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S-Corporation.

• Unlike a C-Corporation, an S-Corporation is not eligible for a dividends received deduction (a tax deduction received by a corporation on the dividends paid to it by other corporations in which it has an ownership stake).

• Unlike a C-Corporation, an S-Corporation is not subject to the 10% of taxable income limitation applicable to charitable contribution deductions.

Who Can Form an S-Corporation?

S-Corporations are more suitable for small and family businesses, and for those who starts their business with small investment. Also, some existing businesses qualify for S-Corporation status.

To form S-Corporation or to change your existing C-Corporation into S-Corporation (also called "Election of S-Corporation Status") certain conditions need to be met:

• S-Corporation cannot have more than 100 shareholders.

• All shareholders must be either U.S. citizens or residents, estates, or certain trusts.

• Can only have one class of stock. Preferred stock is not allowed.

• Profits and losses must be accorded to owners in proportion with their ownership stake.

• Must use the calendar year as its fiscal year unless it can demonstrate to the IRS that another fiscal year satisfies a business purpose.

• Shareholders cannot deduct losses in excess of their investment.

• The corporation cannot deduct fringe benefits given to employees who own more than 2% of the corporation.

S-Corporation Advantages

• Forming S-Corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you have from other sources.

• S-Corporation shareholders are not subject to self-employment taxes. These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.

• When you sell your S-Corporation, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.

Taxation of S-Corporations

As already mentioned above, S-Corporations are not subject to corporate tax rates. Instead, S-Corporation passes-through profit (or net losses) to its shareholders and those profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through (sometimes called "flow-through") nature of the income means that the S-Corporation's profits are only taxed once - at the shareholder level. The IRS explains it this way: "On their tax returns, the S-Corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss".

S-Corporations therefore avoid the so-called "double taxation" of dividends in most states. There are however two exceptions to this rule:

• California: There is a franchise tax of 1.5% of net income of an S-Corporation (minimum $800). This is one factor to be taken into consideration when choosing between an LLC and an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues, may be lower than the 1.5% net income tax. Conversely, on high gross revenue, low profit-margin businesses, the LLC franchise tax fees may exceed the S-Corporation net income tax.

• New York City: S-Corporations are subject to the full corporate income tax at a 8.85% rate. However if the S-Corporation can demonstrate that a portion of its business was done outside the city, that portion will not be subject to the additional tax.

Retaining Profits of S-Corporation

S-Corporations (much like regular C-Corporations) are allowed to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders, and as a result shareholders might be taxed on income they never received (whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out).

Converting S-Corp Back to C-Corp

S-Corporation status is not permanent and can be reversed back if so desired. For example, if the business becomes more profitable and there are tax advantages to being a regular C-Corporation, S-Corporation registration status can be dropped after a certain amount of time.