Definition S Corporation: Everything You Need to Know
An S corporation is a type of corporation with 100 or fewer shareholders that meets certain requirements and opts to be taxed as a partnership.3 min read
The definition S corporation is a type of corporation with 100 or fewer shareholders that meets certain requirements and opts to be taxed as a partnership under Subchapter S of the Internal Revenue Code. This allows an S corporation to avoid the double taxation that affects standard corporations while enjoying corporate benefits such as limited liability protections.
An S corporation is a pass-through tax entity, which means that business income, deductions, losses, and credits are reported on the individual tax returns of each shareholder and taxed only at the individual rate. C corporations are also taxed on these profits at the corporate level, while S corporations are only subject to corporate tax for passive income and built-in gains.
Although the S corporation does not pay corporate income taxes, it must file an annual information return that lists income, depreciation, expenses, and other financial information. They also submit a Schedule K-1 for each shareholder noting his or her percentage of profits and losses.
S Corporation Requirements
Requirements to establish an S corporation are as follows:
- Must be a domestic corporation
- Must have 100 or fewer shareholders, although spouses can count as a single shareholder
- Must issue only one class of stock, though different voting rights within that class are allowed
- Only individuals and certain types of trusts and estates can be shareholders
- Corporations, partnerships, and non-resident aliens cannot be shareholders
- Must not be an insurance company, financial institution, or domestic international sales company
- Must file IRS Form 2553 by March 15 of the effective tax year or by the fifteenth day of the third month of the tax year for S corps that use a fiscal year
- Must have written consent of S corp election from all shareholders
If any of these items are violated at any time, the corporation can lose S tax status and be subject to double taxation as a C corporation. If S status is revoked, it cannot be reestablished for at least five years.
Advantages of establishing an S corporation include:
- A serious commitment to the company that will raise credibility among potential clients, investors, vendors, and employees
- The ability for shareholders to draw salaries as company employees and receive tax-free distributions or dividends, which generates deductions for the business while reducing the shareholder's self-employment tax liability
- Reporting business losses on the individual tax return can help shareholders offset other income
- Free transfer of shares without complicated tax or accounting consequences
- Limited liability protection, which means that shareholders' personal assets are protected from seizure to satisfy business obligations or debts
S Corporation Disadvantages
Potential downsides of forming an S corporation may include:
- Additional IRS scrutiny of shareholder salaries and dividends, possibly resulting in loss of deductions or increased shareholder tax burden
- Termination of S corp status in response to errors with consent, election, notification, filing requirements, or stock ownership
- The time and money required to file S corp election, including the costs associated with filing articles of incorporation, hiring a registered agent, registration fees, annual report fees, franchise taxes, and other taxes and fees depending on the state of establishment
- Dividends paid to high-income shareholders will be taxed at their higher rate
- Shareholders who are not employees cannot deduct business losses
- Certain benefits such as life and health insurance are not necessarily tax-deductible
- Only domestic capitalization can be used
- Shareholders are taxed on all earned business profits for the year even if they do not receive distributions
- Must use the calendar year unless special IRS approval for a fiscal year is obtained
S Corp Taxation
Profits and losses that pass through the S corporation to individual shareholders are reported on the IRS Form 1040. This is an advantage over the tax structure of C corporations, in which profits are taxed at the corporate level when they are earned and at the individual level when they are distributed to shareholders. Even when profits are retained by the S corporation to provide operating capital, shareholders are still required to pay tax on a percentage based on their investment in the business.
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