S Corporation: Tax Election for Small Business Corporations

August 25, 2024 4 min read Finance Business Taxes S Corporation Tax Law Small Business IRS Pass-Through Entity

A comprehensive guide to S Corporations, a tax election that allows small businesses to pass income directly to shareholders, avoiding double taxation.

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An S Corporation, formerly known as a Subchapter S Corporation, is a special tax election that small business corporations can choose under the U.S. Internal Revenue Code. Named after Subchapter S of Chapter 1 of the Internal Revenue Code, this designation allows business income, as well as deductions, credits, and losses to be passed through to shareholders. This means these business activities are reported on the shareholders’ individual tax returns, avoiding the double taxation typically seen with C Corporations.

Eligibility and Formation

Eligibility Criteria

To qualify as an S Corporation, a company must meet the following requirements:

Domestic Corporation: Must be based in the United States.
Eligible Shareholders: Shareholders must be individuals, certain trusts, and estates. Partnerships, corporations, and non-resident aliens cannot be shareholders.
Shareholder Limit: Limited to 100 shareholders.
One Class of Stock: The company can only have one class of stock, though differences in voting rights are permissible.
Election by All Shareholders: All shareholders must consent to the S Corporation election.

Formation Process

Incorporate the Business: Start by forming a standard C Corporation or a Limited Liability Company (LLC) under state law.
File Form 2553: To elect S Corporation status, the corporation must file IRS Form 2553, “Election by a Small Business Corporation,” signed by all shareholders.

Advantages and Disadvantages

Advantages

Pass-Through Taxation: Avoids double taxation by allowing profits and losses to be reported on shareholders’ personal tax returns.
Limited Liability Protection: Provides limited liability to shareholders, protecting their personal assets from business debts and claims.
Tax Savings on Dividends: Shareholders can receive dividends that may be taxed at a lower rate than regular income.

Disadvantages

Restricted Ownership: Limited to 100 shareholders, and cannot include partnerships, other corporations, or non-resident aliens.
Increased Scrutiny: The IRS closely monitors S Corporations for strict compliance with eligibility rules.
Administrative Complexity: Requires careful adherence to requirements and deadlines for maintaining S Corporation status.

Tax Implications

Pass-Through Taxation

The key feature of S Corporations is that income, losses, deductions, and credits pass through to shareholders, who report these on their individual tax returns. This treatment can lead to overall tax savings but requires meticulous documentation and compliance.

Employment Taxes

Shareholders who are also employees must receive reasonable compensation for services rendered, which is subject to payroll taxes. Dividends received by shareholders are not subject to employment taxes but should not be disproportionately high compared to wages to avoid IRS scrutiny.

Comparisons with Other Business Entities

S Corporation vs C Corporation

Taxation: Unlike S Corporations, C Corporations face double taxation—once at the corporate level and again at the shareholder level.
Ownership Flexibility: C Corporations can have unlimited shareholders and multiple classes of stock, offering more flexibility in ownership structure compared to S Corporations.

S Corporation vs LLC

Taxation Options: LLCs offer flexibility in taxation, allowing them to be taxed as sole proprietorships, partnerships, or corporations.
Ease of Formation: LLCs are generally easier to form and manage, with fewer restrictions on ownership and operational structure.

FAQs

What happens if an S Corporation's status is revoked?

If an S Corporation’s status is revoked or terminated, the business will revert to being taxed as a C Corporation, subjecting it to double taxation.

Can an S Corporation have more than one class of stock?

No, an S Corporation can only have one class of stock, although it can issue shares with different voting rights.

Is there a deadline to file Form 2553?

To gain S Corporation status for the current tax year, Form 2553 must be filed no later than two months and 15 days after the beginning of the tax year the election is to take effect.

References

Internal Revenue Service. Form 2553, Election by a Small Business Corporation.
U.S. Small Business Administration. SBA Guide on S Corporations.

Summary

An S Corporation is a tax designation that enables small business owners to benefit from pass-through taxation, thus avoiding the double taxation typical of C Corporations. While it offers significant tax advantages and limited liability protection, it has stringent eligibility requirements and administrative responsibilities. Understanding the implications, procedures, and compliances involved with S Corporations is crucial for businesses considering this election. Through strategic planning and proper management, an S Corporation can be a highly advantageous structure for many small businesses.