S Corporation Rules: Everything You Need to Know
An S corporation is a business entity that allows pass-through taxation through income and losses to the shareholders for corporate taxation purposes.3 min read updated on February 01, 2023
What Is an S Corporation?
An S corporation is a business entity that allows pass-through taxation through income and losses to the shareholders for corporate taxation purposes. An S corporation is one of three of the most popular choices for business owners incorporating their business. The other most common choices are limited liability corporations and C corporations. To qualify as an S corporation, a business must meet the IRS eligibility requirements and follow two steps before they are considered a corporation.
- It must file Articles of Incorporation with their state's Secretary of State office.
- Similar to a C corporation, it must issue stocks as determined by their Articles of Incorporation to directors, owners, and shareholders.
Personal Service Corporation
A PSC, or personal service corporation, is a type of C corporation that receives classification by the IRS for performing services such as consulting. Since C corporations are often assessed with a lower initial rate, often 15 percent on earnings up to $50,000, many businesses will incorporate as an S corporation to avoid being classified by the IRS as a PSC.
How are C Corporations Taxed?
A C corporation is often referred to as a regular corporation and is subject to double taxation. A corporation will file their own Form 1120, or corporate tax return. A corporation can choose to retain its earnings and profits as operating capital or distribute their profits to the shareholders as dividends. When this occurs, the dividends paid to the shareholders will end up being taxed twice, once at the corporate level and again on the shareholder's personal tax return.
How are S Corporations Taxed?
S corporations are not subject to IRS corporate tax rates. In general, an S corporation will be exempt from the federal income tax aside from the tax on certain capital gains. The S corporation will instead use pass-through taxation where the taxes will occur on the profits and losses that the shareholder has accrued on their personal tax return. This ensures that the corporation will only be taxed at the shareholder level.
Similar to C corporations, S corporations can also retain the net profits that they earn for operating capital, though these profits will be treated the same as dividends for tax purposes. Unfortunately, this can result in shareholders having to pay taxes on dividends that they never received. Along with the single taxation, S corporations are attractive to business owners due to their limited liability protection.
What are the Eligibility Requirements for S Corporations?
To be classified as an S corporation, a business will need to meet certain criteria, including:
- The company must be a corporation or entity that operates and is based in the United States.
- The company must have less than 100 total shareholders.
- Shareholders must be estates, individuals, trusts, or a specific exempt organization.
- No shareholders can be a nonresident alien.
- The company stock can only have one class, although it is allowed to have both voting and nonvoting shares. In essence, all investors must have the same dividend and distribution rights.
- A corporation cannot be an ineligible corporation. These corporations include:
- Banks, which utilize a reserve accounting method for bad debts
- An insurance company, which require different taxation
- A corporation treated as a possession
- A domestic international sales corporation.
- The corporation must have a tax year that has been specifically established for business purposes or one that ends on December 31st.
All shareholders must agree to the election of the S corporation status. If these restrictions are not followed, the IRS will automatically classify the business as a C corporation, and it will be subject to double taxation.
Advantages of S Corporations
The advantages of becoming an S corporation often outweigh the disadvantages and include:
- Easier transfer of ownership without tax consequences in the event of an owner's death or departure.
- Limited liability for business debts.
- An unlimited number of management positions with no state residency requirements.
- Shareholders can receive dividends as well as other forms of tax-free distributions.
- S corporations will not have to use the accrual method of accounting unless they have an inventory.
- Owners will not be subject to self-employment taxes that can occur in other tax classifications.
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