What is an S Corporation?
Question: What is an S Corporation?
Answer: An S corporation is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. Generally, S corporations do not pay any federal income taxes. Instead, the corporation's income or losses are passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.
An overview of S corporations
S corporations are typically business corporations formed under state law that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. S status combines the legal characteristics of a corporation under state law with U.S. federal income taxation similar to that of a partnership. The tax rules for S corporation are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379).
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. However, with modern incorporation statutes making the establishment of a corporation relatively easy, firms that might traditionally have been run as partnerships or sole proprietorships are often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form; this is particularly true of firms established prior to the advent of the modern limited liability company. Therefore, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed. Also, 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.
Taxation of S corporations
The S election affects the treatment of the corporation for Federal income tax purposes. The election does not change the requirements for that corporation for other Federal taxes such as FICA and federal unemployment taxes.
Taxation of S corporation distributive shares
While an S corporation is not taxed on its profits, each item of corporate income, losses, deductions, and credit is passed through to its shareholders for federal tax purposes and reported on the shareholders' individual income tax returns. Thus, the owners of an S corporation are taxed on their proportionate shares of the S corporation's profits. The shareholder must pay tax on the income even if the corporation does not make any distribution of cash to the shareholders. Quarterly estimated taxes must be paid by the individual on his or her distributive share of the S corporation's income or suffer tax penalties at the end of the year.
As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders. Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may recategorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for the services they perform in their positions within the company.
Actual distributions of funds, as opposed to distributive shares, typically have no effect on shareholder tax liability. However, a distribution to a shareholder that is in excess of the shareholder's basis in his or her stock is taxed to the shareholder as capital gain.
Conversion from C corporation
S corporations that have previously been C corporations may also, in certain circumstances, pay income taxes on untaxed profits that were generated when the corporation operated as a C corporation. This is very common with uncollected accounts receivable or appreciated assets such as real estate.
Filing Form 1120S
Form 1120S generally must be filed by March 15 of the year immediately following the calendar year covered by the return or, if a fiscal year (a year ending on the last day of a month other than December) is used, by the 15th day of the third month immediately following the last day of the fiscal year. The corporation must complete a Schedule K-1 for each person who was a shareholder at any time during the tax year and file it with the IRS along with Form 1120S. The second copy of the Schedule K-1 must be mailed to the shareholder.
Other taxable income to S corporation shareholders
If a shareholder owns more than 2% of the outstanding stock of an S corporation, amounts paid for group health insurance for that shareholder are included on their W-2 as "wages." The same applies to amounts contributed to Health Savings Accounts (HSA).
Additional differences between S corporations and C corporations
Unlike a C corporation, an S corporation is not eligible for a dividends received deduction. Also unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.
State and local tax considerations
General. Some but not all states recognize a state tax law equivalent to an S corporation. In those states, an S corporation may be treated the same way for state income tax purposes as it is treated for Federal purposes. For most states, an S corporation election at the federal level automatically has the effect of treating the corporation as an S corporation at the state level as well. A few states such as New York and New Jersey require a separate state-level S corporation election in order for the corporation to be treated as an S corporation for state tax purposes. A state taxing authority may require that a copy of the Form 1120S return be submitted to the state with the state income tax return.
California. S corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company and an S corporation in California. For highly profitable enterprises, the LLC franchise tax fees (minimum $800), which are based on gross revenues, may be lower than the 1.5% net income tax. Conversely, for 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 New York City corporate income tax at an 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.
Qualification for S corporation status
In order to make an election to be treated as an S corporation, the corporation:
- Must be a limited liability entity (a corporation, or a limited liability company which has elected to be taxed as a corporation).
- Must have only one class of stock. That means that all profits and losses must be allocated to shareholders proportionately to each one's interest in the business.
- Must not have more than 100 shareholders. Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
- Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: "Election by a Small Business Corporation" with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553. The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often, the IRS will accept a late S election. If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation. If more than 25% of a S-corporation's gross receipts consists of passive income for three consecutive years when the corporation has accumulated earnings and profits, the S corporation will automatically lose its subchapter S status and revert to being a regular C corporation.
Getting HelpIf you are considering incorporation as an option for liability protection for your business, consult with a business attorney in your state that regularly handles business formation and corporate tax issues. Many online services now offer do-it-yourself kits for incorporating but provide no legal advice to you. Incorporating without the assistance of an attorney can result in missed filing deadlines for federal or state tax issues, which can be very expensive. Proper pre-planning and professional assistance with establishing an S corp provides the best protection for your business.
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