A common question that comes up in my practice is ‘What is an S Corporation?’ So I decided to write a blog entry answering this question. Here is my S Corporation overview. The post covers the taxation of S corporations and their shareholders.
The term S Corporation is a tax term only. For state law purposes S corporations are just corporations. However, if your corporation elects to be taxed as a “S corporation” they are taxed much like partnerships for federal (and, in many cases, state) income tax purposes. There are several major federal income tax advantages of operating as an S corporation instead of as a regular C corporation. These advantages include:
- A single level of tax. The income of an S corporation is generally subject to just one level of tax, at the shareholder level. In other words, the income generally is taxed only to the corporation’s shareholders. In contrast, a C corporation pays tax on its earnings, and its shareholders pay a second tax when corporate earnings are distributed to them in the form of dividends.
- The availability of losses. Shareholders of an S corporation generally may deduct their share of the corporation’s net operating loss on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation’s earnings. This pass-through of an S corporation’s losses to its shareholders makes the S corporation form particularly suitable for start-up businesses that are expected to generate losses during their initial stages.
- Income splitting. S corporations can serve as excellent vehicles for splitting income among family members through gifts or sales of stock.
Although operating as an S corporation offers many significant tax benefits, there are also some significant disadvantages associated with electing S status. The primary disadvantages are:
- The exclusion for up to 100% of the gain on the sale of “qualified small business stock” does not apply to the sale of stock in an S corporation.
- Fewer tax-free fringe benefits may be provided to shareholder-employees of S corporations than to shareholder-employees of C corporations.
- Stock in an S corporation can only be transferred to eligible shareholders — individuals, estates, certain trusts, and certain pension plans and charitable organizations. An S corporation cannot have more than 100 shareholders, but married couples and other family members count as one shareholder. A nonresident alien may not be a shareholder. These limitations restrict the sources and amount of equity capital.
- An S corporation may not issued preferred stock, since such stock will constitute a prohibited second class of stock. This limitation also may restrict the sources and amount of equity capital.
- Estate planning for shareholders is generally more complicated when an S corporation is involved.
- Tax rates applicable to individuals may be higher than the rates that would apply to a C corporation at the same income level.
- Since 1997, employee stock ownership plans can be used, but some of their tax advantages are not available to S corporations.
Not all corporations may elect S status. The election is available only to qualifying “small business corporations.” A corporation must formally elect to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation, with the IRS.
An S corporation’s taxable income must be computed in order to determine the items of income or loss to pass through to the shareholders. An S corporation’s taxable income generally is computed in the same manner as that of a partnership. Thus, items of income, gain, loss, deduction and credit, the separate treatment of which could affect the tax liability of a shareholder, must be passed through separately to each shareholder. The tax character of these items is determined at the corporate level, and they retain their character when passed through to the shareholders.
An S corporation that was once a C corporation may be subject to one or more of three separate taxes at the corporate level (e.g., the “built-in gains” tax). This rule is an exception to the general rule that S corporations are not subject to tax.
Items of income, gain, loss or deduction that pass through to a shareholder are reflected in the basis in his or her stock (and, in some cases, in debt, if any, that the corporation owes to the shareholder).
Once an S election is made, it applies for all succeeding years unless the election is terminated. If the election is terminated, S status generally cannot be re-elected for five years. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation’s ceasing to satisfy the eligibility requirements for S status, or by the corporation’s failing a passive investment income test. For example, the election terminates if the S corporation’s stock is acquired by a nonqualified shareholder (e.g., a corporation) or if the number of shareholders exceeds the maximum permitted. The election terminates on the day the eligibility requirement is violated. If the termination is inadvertent, the IRS may allow the corporation to continue as an S corporation if the terminating event is corrected within a reasonable period of time.