S corporation examples help you understand what an S corporation is, how it's formed, and what special tax benefits it receives.

S Corporation

An S Corporation is a regular business corporation that has elected for special tax status with the IRS. It works like a corporation while being taxed like a partnership firm.

For the purpose of taxation, an S corporation passes through its income and losses to its shareholders. The shareholders report the corporation's income and losses in their tax returns and pay taxes at individual levels. This prevents double taxation since the corporation's income is not taxed at the corporate level.

How to Form an S Corporation

When you decide to create an S corporation, you should first determine whether your business qualifies for the election under the IRS rules.

The S corp status is a special status granted by the Internal Revenue Service (IRS) for the purpose of taxation.

You must register your business as a corporation before making the S corp election:

  1. To form a corporation, file the formation documents including the Articles of Incorporation with the secretary of your state.
  2. Obtain all the state and city level licenses and permits applicable to your industry.
  3. Once the corporation is formed, make the S corp election by filing Form 2553 with the IRS.

Go through the instructions for electing S corporation on the IRS website. The U.S. Small Business Association's website contains information on setting up a new business.

If you'd be hiring employees for your corporation, make sure you comply with federal and state provisions regarding employees. You can find the relevant information for this on the U.S. Department of Labor's website. You may also want to undergo online video training for employers offered by the Small Business Association.

Eligibility Criteria for an S Corporation

Not all corporations get to choose the S Corporation status.

In order to be able to make the S corp election, your corporation must meet the eligibility criteria:

  • It should be a domestic corporation.
  • The number of shareholders must be within the specified limit of 100.
  • It should not have any shareholder that is not allowed for an S corporation.
  • It should not have more than one class of stock.
  • The business should not fall under the category forbidden for an S corp structure, such as insurance and domestic international sales.

If your corporation ceases to meet any of these conditions after electing the S corp status, it may be taxed as a regular corporation.

How to Terminate the S Corporation Election

If you'd like to terminate the S corporation election, you should file a statement with the authority that granted you the status. In most of the cases, it would be the Secretary of the State.

The agency authorized to terminate the election will have a set of specific instructions and forms for the termination process. After termination of the S corp election, you must provide certain information to the IRS. The IRS offers detailed information on how you can terminate a business.

What to Do in Case of Inadvertent Termination

Complying with the requirements of S corporation election can often be confusing and difficult. Failure to comply with the requirements may inadvertently terminate the S corporation status.

Keeping in mind the numerous inadvertent terminations taking place, the IRS has come up with solutions to rectify this issue. Contact the IRS or your tax advisor for more information on rectifying an inadvertent S corp termination.

Example of S Corporation Taxation

Let's say, XYZ Inc. is an S corporation, which is owned 60 percent by Tom and 40 percent by Harry. If it makes a net income of $10 million in a financial year, Tom will report $6 million and Harry will report $4 million as income in their personal tax returns.

If the corporation decides to retain the income instead of distributing it, Tom and Harry will still have to pay the taxes. However, they will not have to pay taxes again when the corporation distributes this income in the future.

Since the majority owner (Tom, in this example) has the authority to decide the distribution of income, this decision can often be used to force out a minority owner. In the common corporate parlance, this is referred to as “squeeze-play.”

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