How to use a Book to Grow your Business

An S Corporation is a corporation which has elected to have its profits pass through to its shareholders, in the same manner as a partnership or sole proprietorship. The shareholders of an S Corporation receive the benefit of limited liability, and are treated in the manner of partners for purposes of taxation.

What Corporations Qualify

To qualify as an S Corporation, in broad terms, the corporation:

• May have no more than 100 shareholders, all of whom are individuals, estates, 501(c)(3) corporations or qualifying trusts;
• Must have only one class of stock (although differences in voting rights may be allowed);
• Must be formed in the United States; and
• May not be a bank, insurance company or a Domestic International Sales Corporation (DISC).
• All shareholders must be citizens or residents of the United States. Non-resident aliens may not hold shares.

The S Corporation Election

A corporation must elect to be treated as an S Corporation no later than the fifteenth day of the third month of the tax year to which the election is to be applied or any time in the preceding tax year. If the election is made, the corporate profits are passed through to the shareholders, and thus are not subject to corporate taxation. All shareholders must sign the form making the S Corporation election. After the election is made, the corporation will continue as an S Corporation until either it no longer qualifies for that status or a majority of the shareholders vote to revoke that status. (In some states, you must also elect to be treated as an S Corporation at the state level, in addition to your federal filing.)

Advantages of the S Corporation

The most significant advantages of converting a sole proprietorship or partnership to an S Corporation are limited liability and tax benefits.

While creditors can reach corporate assets, as a general rule they are not able to reach the assets of the corporation's shareholders.
The S Corporation continues pass-through taxation. Thus, in contrast with a C Corporation, its profits are not potentially subject to double-taxation, first as corporate profits and second as personal income when distributed to the shareholders. Thus, when opting between an S Corporation and C Corporation, stockholders should consider the impact of paying taxes at the corporate rate as opposed to their personal marginal tax rates.

Corporate losses may ordinarily be passed through to the shareholders, who can then claim a deduction from their other taxable income.

As distributions from an S Corporation are not wages, they are not subject to self-employment tax. However, any salary received by a shareholder as a corporate officer or employee would remain subject to employment taxes. Any officer who performs significant tasks for the corporation will likely be regarded by the IRS as an employee, and the IRS may reallocate distributions made to an under compensated employee-shareholder as wages, with possible consequent late fees, penalties, and interest.

Due to pass-through taxation, shareholder employees of an S Corporation are less likely to be subject to IRS claims of excessive compensation, as compared to shareholder employees of C Corporations.

You should discuss the full financial and tax benefits and consequences of S Corporation status with your accountant, prior to making the election.

Disadvantages of the S Corporation

Unlike a C Corporation, the S Corporation may not be the subject of a public offering.

The shareholders of an S Corporation are limited in the amount they can deduct as a result of business losses, in rough terms to the amount of their "basis" or investment in the corporation.

There is no flexibility in allocation of profits - profits are allocated in proportion to each shareholder's ownership interest in the corporation. As a consequence, many businesses opt instead to form as limited liability companies, in order to take advantage of the greater flexibility in allocation of profits.

Businesses who wish to seek foreign investors may be burdened by the residency restrictions on shareholders.

Shareholders may find themselves subject to the Alternative Minimum Tax (AMT) based upon corporate earnings allocated to them.

Taxation

Under normal circumstances an S Corporation does not pay corporate income taxes. Instead, the corporate profits are passed through to the shareholders, who report the distribution on their individual tax returns.