S Corporations

Original Content By BizFilings (www.bizfilings.com)

A subchapter S corporation is a standard corporation that has elected a special tax status with the Internal Revenue Service (IRS). S corporations carry the same benefits as C corporations, such protecting the shareholders’ (or owners’) personal assets from the debts and liabilities of the business, unlimited life and tax deductibility of certain business expenses. The primary differences between S corporation s and C corporations are the way they are taxed and also the ownership restrictions imposed upon S corporations.

When deciding which entity structure is most appropriate for their business, small business owners often view the potential double taxation of profits associated with C corporations as the primary disadvantage to forming a standard corporation. With C corporations, the profits are taxed first at the corporate level, and then taxed again at the individual level if they are distributed to shareholders in the form of dividends. Shareholders must report dividends as personal income and pay taxes on that income.  

Double taxation can be eliminated by completing the S corporation election with the IRS. S corporations are taxed as pass-through taxation entities, similar to general partnerships and most limited liability companies. While the profits of an S corporation are reported at the corporate level, taxes are not paid at the corporate level. Instead, the profits are passed-through to the individual tax returns of the shareholders and are taxed at the individual rate. If the S corporation reports a loss, the amount of the loss is also passed-through and reported on tax returns of the shareholders.

Keep in mind, not all C corporations can make the S corporation election with the IRS, as the IRS has placed restrictions on S corporations. Current restrictions include:

  • Shareholders must number fewer than 75, and all shareholders must consent in writing to the S corporation election.
  • Shareholders must be individuals, estates, or certain qualified trusts.
  • Shareholders cannot be non-resident aliens.
  • S corporations can have only one class of stock (disregarding voting rights)

To be classified as an S corporation, a corporation must make a timely filing of Form 2553 with the IRS. IRS instructions indicate that the form must be completed and filed:

  1. At any time before the 16 th day of the 3 rd month of the tax year if filed during the tax year the election is to take effect, or
  2. At any time during the preceding tax year. An election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2.5 months long is treated as timely made for that tax year.

An election made after the 15 th day of the 3 rd month but before the end of the tax year is effective for the next year. For example, if a calendar tax year corporation makes the election in April 2005, it is effective for the corporation’s 2006 calendar tax year.

For questions on whether the S corporation structure is best for your particular business, it is best to seek the advice of an attorney or accountant.

C Corporations

The standard corporation, also called a C corporation, is a very common business structure. Corporations are separate legal entities that are owned by shareholders. Conversely, sole proprietorships and partnerships are not separate legal entities. They are considered to be the same as the owner(s). In order to form a corporation, the appropriate formation documents, usually called the articles of incorporation or a certificate of incorporation, must be filed with the state and the state filing fees be paid.

The primary advantage of incorporating a business is the limited liability the corporate entity affords its shareholders. Typically, shareholders are not personally liable for the debts and obligations of the corporation; thus, creditors will not come knocking at the door of a shareholder to pay debts owed by the corporation. In a partnership or sole proprietorship the owner’s personal assets may be used to pay debts of the business.

Other advantages of incorporating a business include:

  • Incorporating may establish credibility for a new business with potential customers, employees, vendors, and partners.
  • The ownership of a corporation is easily transferable through the sale of stock.
  • Corporations have unlimited life extending beyond the illness or death of owners.
  • Certain expenses, such as insurance, travel, and qualified retirement plans are typically tax-deductible.
  • Additional capital can be easily raised through the sale of stock (shares) in a corporation.

The main disadvantage to forming a C corporation is often considered to be the potential for double taxation. C corporations are considered separately taxable entities by the Internal Revenue Service (IRS), and taxes must be paid on the profits of the corporation. If a corporation then distributes its profits to shareholders in the form of dividends, the dividend income is also taxed as regular income to the shareholders. In this case, the corporation’s profits are taxed twice, first as income to the corporation and second as dividend income to the shareholder, creating the “double-tax.”

However, not all income a shareholder receives from a C corporation is subject to the double tax. For example, if the shareholder is also an employee of the corporation, that shareholder will most likely receive a salary payment from the corporation. As long as the salary paid to the shareholder is considered by the IRS to be reasonable (or similar to the market salary rates for that position), it is treated as a business expense and is deductible to the corporation. This helps reduce the amount of taxable income the corporation has.

In order to eliminate the possibility of double taxation, C corporations can elect to be taxed as an S corporation with the IRS. With S corporation s, the profits and losses of the corporation are reported on the individual tax returns of the shareholders, and any necessary tax is paid at the individual level. This taxation method is called “pass-through” taxation, since the profit or loss of the corporation is passed through to the shareholders.

 

Other aspects of C corporations that can be considered disadvantages include:

 

  • Corporations are more expensive to form than sole proprietorships and partnerships.
  • There are more corporate formalities, such as annual paperwork, and more state and federal rules and regulations, than with sole proprietorships and general partnerships.

When evaluating whether the corporate structure is right for your particular business, it is advisable to first determine the goals of your business, and then to assess the advantages and potential disadvantages of the different business structures in relation to those goals. You may also wish to seek the advice of an attorney or accountant.

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