S corporation qualifications are strict and set forth by the rules of Internal Revenue Code, Subchapter S. S corporations are unique in that they can have up to 100 shareholders and elect to pass income and/or losses through to individual shareholders.

To elect S corporation status, you must meet specific criteria and file documentation with the IRS within a specified period. Companies that qualify file IRS Form 2553 to become S corporations. Congress created the tax code for S corporations in 1958. It was devised to help encourage small and family businesses while eliminating the double taxation traditional corporations are subject to.

How C Corporations vs. S Corporations Are Taxed

Regular corporations are taxed as separate entities. They file their own tax forms (IRS Form 1120) and have their own tax rates. C corporations can retain income as part of their operating capital, or they can pay dividends to their shareholders. These dividends are taxed twice, once at the corporate level and again on the individual shareholder's return.

S corporations offertax advantages while still preserving some flexibility in ownership. They only file taxes once a year and are not subject to double taxation. An S corporation is generally exempt from federal income tax, except for taxes on passive income and certain capital gains, per the IRS. It passes profits (or losses) through to its shareholders. The profits are taxed at individual rates and reported on the shareholder'sForm 1040.

S corporations can choose to keep net profits as operating capital like C corporations do, but the profits are treated as if they were distributed to the shareholders. This means an S corporation's shareholders can be taxed on income they never received. With C corporations, they're only taxed on dividends that are paid out.

Applying for S Corporation Status

To apply for S corporation status, you need to be:

The corporation must adopt one of these tax years:

  • Ending on December 31.
  • Ownership tax year.
  • Natural tax year.
  • Tax year selected from Section 444.
  • Any other type of tax year the company can establish a business need for.

Other requirements the S corporation must meet include:

  • Each shareholder must consent to S corporation status.
  • The corporation cannot have more than 100 shareholders.
  • The company can only offer one class of stock.
  • Family members, such as husbands and wives, can be treated as one shareholder.
  • Shareholders can only be individual people, certain trusts and exempt organizations, and estates.
  • Nonresident aliens cannot be shareholders.
  • S corporations cannot be certain types of ineligible corporations, such as an insurance company taxed under subchapter L of the Internal Revenue Code.

Typically, partnerships and other corporations are not allowed to be shareholders in S corporations. Tax-exempt organizations under Section 501(a) and nonprofits that fall under Section 501(c)(3) can own stock in S corporations. A select group of trusts, such as qualified subchapter S trusts (QSSTs), can also own stock in an S corporation.

If you allow a prohibited person or entity to have stock, you might have your S corporation status revoked immediately. If you are caught violating any rules, you cannot elect to be an S corporation again for at least five years.

Advantages of S Corporation Status

  • S corporations don't pay federal tax except on passive income and some capital gains.
  • S corporations avoid double taxation by passing company profits through to their shareholders.
  • The company's profits are only taxed once at the shareholder level.
  • S corporations provide some asset protection.
  • Typically, shareholders are not personally responsible for the company's debts and liabilities. In most cases, creditors cannot go after personal assets.
  • S corporation owners have flexibility on how to characterize income for tax purposes.
  • S corporation owners can also be employees and receive salaries.
  • You can also be paid dividends that might be tax-free or taxed at a lower rate than the employee salary.

This last point can reduce self-employment tax liability, provided you calculate salary and dividends/distributions properly. This is to keep you from paying yourself an overly low salary and prevent companies from not paying self-employment taxes.

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