S Corp Flow Through: Everything You Need to Know
S corporation flow through refers to the tax process in an S corporation, whereby corporate income will pass through to the personal tax returns of the shareholders3 min read
S corporation flow through refers to the tax process in an S corporation, whereby corporate income will pass through to the personal tax returns of the shareholders. An S corporation (S corp) is a preferred business structure for many business owners because it gives them liability protection and other benefits of a corporation, while enabling them to avoid double taxation. However, this type of business entity also comes with certain risks and disadvantages.
What Is an S Corporation?
Also known as a subchapter corporation or small business corporation, an S corporation is a tax code the Congress enacted into law in 1958. It was designed to promote and support the formation of small businesses and family businesses by helping them avoid the double taxation that affects ordinary corporations.
An S corporation refers to a corporation that has been organized to pay taxes as a flow-through entity, just like a limited partnership or a limited liability company (LLC). The "S" is an IRS code section that enables the shareholders of an S corporation to pay taxes only at the individual level rather than both the individual and corporate levels.
The S corp business structure is an attractive option for entrepreneurs because of its single taxation and limited liability protection. An eligible domestic corporation that converts to an S corporation files a corporate tax return, or IRS Form 1120S. However, its profits will flow through to its shareholders, who will in turn report them on their personal income tax returns, or Schedule E forms.
Eligibility Requirements for S Corp Election
A corporation has to meet the following requirements to be eligible for S corporation status:
- The company must be a domestic corporation or a domestic entity that qualifies to be a corporation and files IRS Form 2553 on time.
- The company has 100 or fewer shareholders.
- The shareholders must be individuals, estates, certain trusts, or certain tax-exempt organizations.
- The shareholders must be U.S citizens or resident aliens, not nonresident aliens.
- All shareholders must consent to the S corp election.
- The company must have only one class of stock.
- The company is not a possessions corporation, a financial institution using the Section 585 reserve method of accounting for bad debts, an insurance company being taxed under subchapter L, or an existing or former domestic international sales corporation (DISC).
- The company must adopt an appropriate tax year.
Advantages of an S Corporation
- Unlimited number of management personnel and no state residency requirements.
- Court-recognized existence, which protects the owners from being personally liable for the corporation's financial obligations.
- Flow-through taxation, allowing profits to pass through to the personal tax returns of shareholders.
- Ability to designate income as salary or distribution. This enables shareholders to allocate a greater portion of income to distribution so as to reduce self-employment tax.
- Good privacy protection.
- Easy ownership transfer, without causing substantial tax consequences, terminating the corporation, complying with complex accounting rules, or adjusting property basis.
- Ability to use the cash method of accounting instead of the more complicated accrual method.
Disadvantages of an S Corporation
- Limited number of shareholders.
- At the shareholder level, shares can be seized or sold in court proceedings.
- Owners or employees who hold 2 percent or more of the corporation's shares are not eligible for tax-free benefits.
- High-income shareholders have to pay higher taxes on their distributions because pass-through taxes are paid at the individual rate.
- Control of the company is in the hands of the shareholders, making an S corp an unsuitable vehicle for estate planning.
- If the S corp tax status is compromised, the IRS will charge back taxes for three years, revoke status, and impose a five-year wait for regaining tax status.
- Capital gain on the sale of assets will result in higher taxes than with a limited partnership, LLC or other pass-through entities. This makes an S corp unsuitable for holding appreciating investment.
- Owners of an S corporation may be asked to reallocate their incomes and pay higher taxes by the IRS if they are found to characterize their salary payments unfairly
- An S corporation is subject to the same requirements as a regular corporation. This means it has to pay higher tax service and legal costs.
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