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Legal Dictionary
S Corporation
An S corporation combines the limited liability of a corporation and the "pass-through" tax-treatment of a partnership. It is a business structure suited to small business owners who want the continuity and liability protection of a corporation but wish to be taxed as a sole proprietorship or partnership. S corporation status is appropriate for:
  • Companies expecting start-up losses during the initial years of operation.
  • Companies expecting start-up losses during the initial years of operation.
  • Companies with no intent of going public in the future.
  • Companies that do not expect to issue multiple classes of stock
  • Companies that might be subject to the Alternative Minimum Tax.
  • Owners who live in a state with no personal state income tax.
  • Companies whose sales are less than $250,000 per year (as a rough guideline).
  • Shareholders who earn less than maximum amount subject to Social Security tax ($87,000 for 2003).
  • Shareholders who actively participate in the business.
  • Companies that plan to distribute most of its annual profits to its shareholders.
Forming a S corporation begins with a C corporation. An S corporation is essentially a C corporation that has elected to become an S corporation for tax treatnment purposes. The S corporation election form 2553 is filed with the Internal Revenue Service. Instead of being taxed at the corporate level, the income “passes through” to the individual shareholders. This is the same basic "pass-through" treatment afforded partnerships and LLCs. Any income or loss generated by the S corporation is reported on the individual tax returns of the shareholders, rather than being taxed at the corporate level. Thus, the S corporation election is a popular choice for most small businesses. In this case the corporation cannot have more than 75 shareholders. There are restrictions regarding who may and may not own stock. Generally, non-resident aliens, trusts, other S corporations, C corporations (with few exceptions) may not own stock. An S corporation must have a maximum of 75 shareholders who are individuals (though certain types of trusts and estates may qualify). Once a corporation makes the Subchapter S election to be an S corporation, profits and losses are passed through the corporation and are reported on the individual tax returns of the respective shareholders of the S corporation. Thus, the key distinction of the S corporation is that profits and losses are not taxed at the corporate/business level like they would be if the corporation remained as a C corporation. REQUIREMENTS/FILINGS An S corporation follows the same state formalities as does a C corporation, such as filing articles of incorporation and paying state fees. S corporations must make a special tax election under sub-chapter S of the Internal Revenue Code by filing IRS Form 2553. The election, which is made by filing form IRS 2553, must be made by March 15 in order for the election to take effect that year. If the election is made after March 15 but within 75 days of the incorporation date, the election will be effective for the next calendar year. If the S corporation is not a calendar-year taxpayer, the election must be made within 75 days of the beginning of the corporation’s tax year. Some states also require a filing of S corporation election. The S corporation must complete and file IRS Form 1120s to report its annual income to the IRS each year. If your corporation has a tax-year end date other than December 31, you must file for permission from the IRS. SHAREHOLDERS ALL shareholders of the corporation must be U.S. Citizens or have U.S. Residency Status. If, for any reason, shares are somehow sold or transferred (even if by will, divorce, or other means) to a shareholder who is a foreign national, the corporation will lose its S corporation status and be treated as a C corporation. S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs, or partnerships. 75 Shareholders Maximum. S corporations may have only one class of stock. An S corporation that loses its status as such may no re-elect S corporation status for a minimum of five years. INCOME An S corporation’s passive income level must not exceed the 25% of gross receipts over a consecutive three year period limit. ADVANTAGES For certain individuals, the pass-through treatment of income will result in lower tax liability than taxation at the corporate level. Stock may be issued to the public as long as the 75 shareholders limit is not exceeded. S corporations enjoy the limited liability attached to corporations. The corporation can pay the owner a reasonably small salary (which is subject to Social Security and Medicare tax). Then, the corporation can pay a relatively large distribution of profits (on the Schedule K-1 form – which is not subject to Social Security and Medicare tax). This may save the Social Security/Medicare tax on a sizable chunk of income. It is relatively easy to transfer ownership and add new owners. DISADVANTAGES Individuals who benefit from the lower tax rate paid by corporations should not apply for S corporation status. S corporation status imposes limitations on ownership of company stock, such as foreign ownership. An S corporation may only offer one class of stock and an S corporation is limited to a maximum of 75 shareholders. If you plan to invest corporate profits back into the corporation and will only draw a nominal salary, you may still have tax liability on the balance of the dividends that you reinvested in the corporation. When a shareholder of an S corporation is sued in a personal (not a business) lawsuit, the shares of stock are assets that may be seized. Separate tax returns must be filed and there is a possibility of double taxation at the shareholder and corporate levels.

Additional Definitions

S Corporations

A small business may operate under various legal forms. The most common of these, particularly for new startups, is the sole proprietorship. The individual who owns the business receives all of its income and is responsible for all of the business's debts—including other liabilities to which the business may be subject (e.g. a customer slipping on that banana peel in the store). Under a sole proprietorship, the individual and the business are the same thing. If the business fails, the owner may have to sell his or her house and other goods to satisfy its debts. The principal advantage of incorporation is that the owner as a person is separated from the corporation, the latter viewed as an artificial "person." They are now two, not one. The corporation carries its own liabilities. When the corporation fails, the liability of its owners is limited to whatever they have invested—and no more. The business owner who started a business with $10,000 may lose the $10,000—but not the $300,000 he or she owns in other assets. The downside of incorporation is that the income of the corporation is taxed separately—and the owner gets his or her share only after the corporate tax has been deducted. The owner also then owes additional taxes on his or her earnings. Thus double taxation is involved. As a sole proprietor, the owner is taxed once but is personally exposed to all of the liabilities of the business. As a corporate entity, the owner is shielded from liabilities but is taxed twice. Is there a way to have the best of both worlds? Yes, there is. It is called the S Corporation. The S corporation derives its name from Subchapter S of the Internal Revenue Code which provides corporations a "tax election" option—a choice on how they want to be taxed. Under Subchapter S, a company may elect to pass all of its profits to its shareholders directly. The shareholders are then responsible for paying taxes on this income stream. The corporation itself is not taxed. Meanwhile the limited liability benefits of the regular corporate form continue. Not all corporations, however, qualify for the Subchapter S tax election. The company may only have a maximum of 75 investors. They must all agree to this choice. All must be residents in the U.S. or U.S. citizens. The IRS also excludes certain types of companies described below. A regular corporation, called a C corporation, can convert itself to S status—and thus have it both ways.

BECOMING AN S CORPORATION

Filing with the Internal Revenue Service

Once a business has incorporated in the usual way and has filed its articles of incorporation, it can elect S corporation status by filing Form 2553 with the IRS. All of the corporation's shareholders must sign this form or file special shareholder consent forms. The rules apply to anyone who has held stock in the company during the current tax year. To be eligible for S corporation status for the current tax year, a corporation must file the form by the fifteenth day of the third month of the corporation's tax year. Once the form has been filed, it is not necessary to file every year.

Eligibility

For a corporation to be eligible for S corporation status, the following conditions must be met and maintained:
  • The business must have become a corporation prior to filing for S corporation status. See the entry Incorporation for more information on this process.
  • The business must also have no more than 75 stockholders. Until the Small Business Job Protection Act of 1996 was passed, corporations with more than 35 shareholders were disqualified.
  • All of the business's stock must be owned by individuals who reside in or are citizens of the United States. Estates or trusts may be allowed as stockholders, but corporate or foreign investors are not allowed. This includes other businesses that are not corporations, such as partnerships or sole proprietorships. This provision, therefore, excludes corporate subsidiaries from claiming S corporation status.
  • The business must issue only one class of stock. This means that with the purchase of stock must come the same economic rights, such as receiving dividends or compensation in the event of liquidation at the same time and in the same amount per share as all other shareholders. Voting rights may differ amongst the shareholders without being considered a sign of the possession of different classes of stock.

Ineligible Businesses

Those businesses that are ineligible for S corporation status include:
  • All financial institutions, such as banks and savings and loans.
  • Insurance companies.
  • Businesses that receive 95 percent or more of their gross income from exports (also known as DISCs, Domestic International Sales Corporations).
  • Corporations that use the possessions tax credit (a type of foreign tax credit).
  • C Corporations that have been S corporations within the last five years.

ADVANTAGES

The chief advantage of the S corporation is its treatment under the tax law, particularly if the company routinely pays high dividends. Under the C form, stockholders actually "feel" the double taxation of corporate profits only when they get dividends: under an S form, they would get more money. S corporation stockholders also get assigned losses if the company sustains them. These losses do not require stockholders to pay any money to the company but allow them to factor the reported losses into their own income taxes and thus reduce their taxes on other income.

DISADVANTAGES

Paying Taxes on "Absent" Income

Most healthy corporations reinvest all or substantial portions of their profits into operations to fund growth. Dividends paid are therefore just a portion of all profits. In C corporations, stockholders only pay taxes on dividends, year to year, and are not liable for taxes on the total profit made. But when the S corporation retains its profits for growth, stockholders must pay taxes on that profit even though they do not get a check in the mail—and the higher the profits, the more rapid the growth, the higher the taxes. This structural arrangement can thus produce tensions between stockholder and the corporation—stockholders either required to keep "investing" in a going concern indirectly by paying its taxes or, conversely, pressuring the corporation to distribute more of its profits and thus potentially slowing the company's growth.

Taxed Fringe Benefits

Unlike C corporations—but like partnerships—S corporations may not deduct fringe benefits, given to shareholders who are also employees, as a business expense. As a result, shareholder-employees must pay taxes on those benefits. These rules apply to all shareholders who own more than two percent of the corporation's stock and are employees of the corporation. But all employees who are not stockholders may receive benefits without paying taxes.

Pay Vs. Profit Sharing

S corporations must be careful to pay stockholders who work for the corporation salaries "deemed reasonable" by industry standards. The temptation exists to pay stockholders low salaries and to compensate them, instead, from profits—thus avoiding payroll taxes. But if the stockholder-employee is not paid at a reasonable rate, the IRS may require the stockholder to pay payroll taxes on the totality of the income received from the S corporation—which may be substantial.

State and Local Taxes

S corporations are sanctioned under federal tax laws which may not be matched by local and state governments. Thus S corporations may still have to pay taxes as corporations to states and localities.

Record Keeping

S corporations must act like S corporations and maintain careful records. This is not, per se, a disadvantage of the form: after all, all businesses should keep good records. But some business owners see the S corporation as merely one way to escape liabilities by gaining the benefits of limited liability while continuing to operate as sole proprietorships. Under prevailing law, a corporation (S or C) must adhere to regular forms: it must separate personal from corporate accounts, hold regular directors' and shareholders' meetings, take minutes, and also use the appropriate corporate designation on its documents and stationary. Failing to adhere to these requirements, the S corporation may not prevail in court in the case of a liability action, with the result that the stockholders are severally and individually held to be liable.

TERMINATING S CORPORATION STATUS

An S corporation may voluntarily revoke its status if it finds that S status is no longer beneficial; it may also lose the status involuntarily. In the first case, a majority of the stockholders is required to make the decision, and a simple notice to the IRS is all that is required. In the second case, any act which disqualifies the corporation's eligibility for S status will result in the termination of that status effective on the date that the infraction occurs. An example of such a disqualification would be acquiring a single foreign stockholder living abroad. In either case, the corporation becomes a C corporation in the absence of S corporation status.
SEE ALSO C Corporation; Incorporation; Professional Corporation

BIBLIOGRAPHY

Adkisson, Jay, and Chris Riser. Asset Protection. McGraw-Hill, 2004. Fishman, Stephen. Working for Yourself: Law and Taxes for Independent Contractors, Freelancers and Consultants. Nolo, 2004. Mancuso, Anthony. LLC Or Corporation? Nolo, 2005. Nathan, Karen, and Alice Magos. Incorporate! McGraw-Hill, 2003. U.S. Small Business Administration. "Forms of Business Ownership." Available from http://www.sba.gov/starting_business/legal/forms.html. Retrieved on 5 June 2006.
                            Hillstrom, Northern Lights                              updated by Magee, ECDI