The S corporation is often more attractive to small-business owners than a standard (or C) corporation. That’s because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

Requirements:

• Be a domestic corporation

• Have only allowable shareholders. May be individuals, certain trusts, and estates and may not be partnerships, corporations or non-resident alien shareholders

• Have no more than 100 shareholders

• Have only one class of stock

• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Taxation:

Distributions: While an S corporation is not taxed on its profits, the owners of an S corporation are taxed on their proportional shares of the S corporation’s profits.

Actual distributions of funds, as opposed to distributive shares, typically have no effect on shareholder tax liability. The term “pass through” refers not to assets distributed by the corporation to the shareholder, but instead to the portion of the corporation’s income, losses, deductions or credits that are reported to the shareholder on Schedule K-1 and are shown by the shareholder on his or her own income tax return. 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.

Taxable Income to Shareholders: If a shareholder owns more than 2% of the outstanding stock, 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).

State Tax: States impose tax laws and regulations for corporate income and distributions, some of which may be directed specifically at S Corporations. Some but not all states recognize a state tax law equivalent to an S corporation, so that the S corporation in certain states may be treated the same way for state income tax purposes as it is treated for Federal purposes. A state taxing authority may require that a copy of the Form 1120-S return be submitted to the state with the state income tax return.

Some states such as New York and New Jersey require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.

Advantages:

Establishing an S corporation may help establish credibility with potential customers, employees, suppliers, and investors by showing the owner’s formal commitment to the company. Also, the S corporation does not pay federal taxes at the entity’s level. Saving money on corporate taxes is beneficial, especially when a business is newly established. Other advantages include the transfer of interests in an S corporation without facing adverse tax consequences, ability to adjust property basis, and complying with complex accounting rules.

Shareholders can be company employees, earn salaries, and receive corporate dividends that are tax-free if the distribution does not exceed their stock basis. If dividends exceed a shareholder’s stock basis, the excess is taxed as capital gains. Characterizing distributions as salary or dividends may help the owner reduce liability for self-employment tax while generating business-expense and wages-paid deductions. 

Disadvantages:

Because S corporations can disguise salaries as corporate distributions to avoid paying payroll taxes, the IRS scrutinizes how S Corporations pay their employees. An S corporation must pay reasonable salaries to shareholder-employees for services rendered before distributions are made. Noncompliance such as mistakes in an election, consent, notification, stock ownership, or filing requirements, while rare, may result in the termination of an S corporation. Quick rectification of noncompliance errors can avoid any adverse consequences. 

In many states, owners pay annual report fees, a franchise tax, and other miscellaneous fees. However, the charges are typically inexpensive and may be deducted as a cost of doing business. 

S Corporations vs. C Corporations:

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 proprietorship 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.

Unlike a C corporation, an S corporation is not eligible for a dividend received deduction.

Unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.