An S corporation or S-corp,
for United States federal income tax purposes, is a corporation that
makes a valid election to be taxed under Subchapter S of Chapter 1 of
the Internal Revenue Code.
In general, S Corporations do not pay any
income taxes. Instead, the corporation's income or losses are
divided among and passed through to its shareholders. The
shareholders must then report the income or loss on their own
individual income tax returns.
An overview of S corporations
S corporation provides many of the benefits of
partnership taxation and at the same time gives the owners limited
liability protection from creditors. The S corporation rules are
contained in Subchapter S of the Internal Revenue Code (1361-1379). S
status combines the legal environment of C corporations with taxation
similar to taxation of partnerships.
S corporations are treated as corporations
under state law. They are recognized as separate legal entities
and generally provide shareholders with the same liability protection
afforded by C corporations. For Federal income tax purposes,
however, taxation of S corporations resembles that of
partnerships. As with partnerships, the income, deductions, and
tax credits of an S corporation flow through to shareholders annually,
regardless of whether distributions are made. Thus, income is
taxed at the shareholder level and not at the corporate level.
Payments to S shareholders by the corporation are distributed tax-free
to the extent that the distributed earnings were previously
taxed. Also, certain corporate penalty taxes (e.g., accumulated
earnings tax, personal holding company tax) and the alternative minimum
tax do not apply to an S corporation.
Unlike C corporation, an S corporation is not eligible for a dividends received deduction.
Unlike C corporation, an S corporation is not
subject to the 10 percent of taxable income limitation applicable to
charitable contributions.
Qualification for S corporation status
In order to make an election to be treated as
an S corporation, the following requirements must be met:
- Must be an eligible entity (a domestic corporation, or a limited liability company).
- Must have only one class of stock.
- Must not have more than 100 shareholders.
- Spouses
are automatically treated as a single shareholder. Families, defined as
individuals descended from a common ancestor, plus spouses and former
spouses of either the common ancestor or anyone lineally descended from
that person, are considered a single shareholder as long as any family
member elects such treatment.
- Shareholders
must be U.S. citizens or residents, and must be physical entities (a
person), so corporate shareholders and partnerships are to be excluded.
However, certain tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
- Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.
If a corporation meets the foregoing
requirements and wishes to be taxed under Subchapter S, its
shareholders may file Form 2553:
"Election by a Small Business Corporation" with the Internal Revenue
Service (IRS). The Form 2553 must be signed by all of the
corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553.
The S corporation election must typically be
made by the fifteenth day of the third month of the tax year for which
the election is intended to be effective, or at any time during the
year immediately preceding the tax year. Congress has directed the IRS
to show leniency with regard to late S elections. Accordingly, often,
the IRS will accept a late S election.
Some states such as New York and New Jersey
require a separate state-level S election in order for the corporation
to be treated, for state tax purposes, as an S corporation.
If a corporation that has elected to be
treated as an S corporation ceases to meet the requirements (for
example, if as a result of stock transfers, the number of shareholders
exceeds 100 or an ineligible shareholder such as a nonresident alien
acquires a share), the corporation will lose its S corporation status
and revert to being a regular C corporation.
Taxation issues
The S election affects the treatment of the
corporation for Federal income tax purposes. The election does
not change the requirements for that corporation for other Federal
taxes such as FICA and Federal unemployment taxes.
FICA
As is the case for any other corporation, the FICA tax
is imposed only with respect to employee wages and not on distributive
shares of shareholders. Although FICA tax is not owed on
distributive shares, the IRS and equivalent state revenue agencies may
re-categorize distributions paid to shareholder-employees as wages if
shareholder employees are not paid a reasonable wage for the services
they perform in their positions within the company.
Distributions
Actual distributions of funds, as opposed to
distributive shares, typically have no effect on shareholder tax
liability. The term "pass through" refers not to assets
distributed by the corporation to the shareholder, but instead to the
portion of the corporation's income, losses, deductions or credits that
are reported to the shareholder on Schedule K-1 and are shown by the
shareholder on his or her own income tax return. However, a
distribution to a shareholder that is in excess of the shareholder's
basis in his or her stock is taxed to the shareholder as capital gain.
Conversion from C Corporation
S corporations that have previously been C corporations
may also, in certain circumstances, pay income taxes on untaxed profits
that were generated when the corporation operated as a C
corporation. This is very common with uncollected accounts
receivable or appreciated real estate.
Example: If an S corporation that was formerly a C corporation sells an appreciated asset (such as real estate) and the appreciation occurred during the time the corporation was a C corporation, the S corporation will probably pay C corporation
taxes on the appreciation--even though the corporation is an S
corporation. This Built In Gain (BIG) tax rate is 35% on the
appreciated property, but is only realized if the BIG property is sold
within 10 years.
Taxation of S Corporation Distributive Share
While an S corporation is not taxed on its
profits, the owners of an S corporation are taxed on their proportional
shares of the S corporation's profits.
Example: Widgets Inc, an S-Corp, makes $10,000,000 in net income
(before payroll) in 2006 and is owned 51% by Bob and 49% by John.
Keeping it simple, Bob and John both draw salaries of $94,200 (which is
the Social Security Wage Base for 2006, after which no further Social Security tax is owed).
Employee salaries are subject to FICA tax
(Social Security & Medicare tax) --currently 15.3 percent--half of
which is paid by the employer and half by the employee. The
distribution of the additional profits from the S-Corp will be done
without any further FICA tax liability.
Widgets Inc now has $9,797,187 of net income
for 2006, after paying salaries ($10,000,000 - $94,200 * 1.0765
[employer FICA] * 2 employees). On Bob's personal tax return, he
will report $4,996,565 of business income (in addition to his $94,200
salary), and John will report $4,800,622. Also, remember that Bob
and John each had the employee half of the FICA tax withheld from their salaries (94,200 * 0.0765 = 7,206.30 each).
If for some reason, Bob (as the majority
owner) were to decide not to distribute the money, both Bob and John
would still owe taxes on their pro-rata
allocation of business income, even though neither received any cash
distribution. To avoid this "phantom income" scenario, S
corporations commonly use shareholder agreements that stipulate at
least enough distribution must be made for shareholders to pay the
taxes on their distributive shares.
Quarterly estimated taxes must be paid by the
individual to avoid tax penalties, even if this income is "phantom
income".
Bob and John will recognize significant tax
savings compared to drawing the remainder of the business income as a
salary subject to FICA taxation. While they have paid the maximum
salary for which Social Security tax is assessed, there is no wage base
for the continuation of the 1.45 percent Medicare tax portion of
FICA. By avoiding the employer and employee portions of FICA on
this amount (2.9 percent) they will together save a total of $284,118.
The difference would be even greater,
percentage-wise, if Bob and John were paying themselves less than the
Social Security Wage Base, as the Social Security portion of FICA is
12.4 percent (total for the employer and employee halves).
IRS Study of S Corporation Reporting Compliance
In 2005, the IRS launched a study to assess
the reporting compliance of S corporations. The study began in
late 2005 and examined 5,000 randomly selected S corporation returns
from tax years 2003 and 2004. The IRS intends to use the results
to measure compliance in recording of income, deductions and credits
from S corporations, and to formulate future audit criteria to better
target likely non-compliant returns. This is part of a larger IRS
effort to improve tax compliance and reduce the estimated $300 billion
gap in gross reported figures each year. A large portion of that
gap is thought to come from small businesses, and particularly S
Corporations, which are now the most common corporate entity, numbering
over 3 million in 2002, up from about 750,000 in 1985.
Filing Form 1120S
Form 1120S generally must be filed by March 15th of
the year immediately following the calendar year covered by the return
or, if a fiscal year (a year ending on the last day of a month other
than December) is used, by the 15th day of the third month immediately
following the last day of the fiscal year. The corporation must
complete a Schedule K-1 for each person who was a shareholder at any
time during the tax year and file it with the IRS along with Form
1120S. The second copy of the Schedule K-1 must be mailed to the
shareholder.
Some but not all states recognize a state tax
law equivalent to an S corporation, so that the S corporation in
certain states may be treated the same way for state income tax
purposes as it is treated for Federal purposes. A state taxing
authority may require that a copy of the Form 1120S return be submitted
to the state with the state income tax return.
California, New York City additional taxes
S-corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company
and an S-corporation in California. On highly profitable
enterprises, the LLC franchise tax fees, which are based on gross
revenues (minimum $800), may be lower than the 1.5% net income tax.
Conversely, on high gross revenue, low profit-margin businesses, the
LLC franchise tax fees may exceed the S corp net income tax.
In New York City, S-corporations are subject
to the full corporate income tax at a 8.85% rate. However if the
S-corporation can demonstrate that a portion of its business was done
outside the city, that portion will not be subject to the additional
tax.
A C corporation or C corp. is a corporation in
the United States that, for Federal income tax purposes, is taxed under
26 U.S.C. § 11 and Subchapter C (26 U.S.C. § 301
et seq.) of Chapter 1 of the Internal Revenue Code. Most major
companies (and many smaller companies) are treated as C corporations
for Federal income tax purposes.
C corporation vs. S corporation
The income of a C corporation is taxed, whereas the income of an S corporation
(with a few exceptions) is not taxed under the Federal income tax
laws. The income, or loss, is applied, Pro Rata, to each
Shareholder and appears on their tax return as Schedule E
income/(loss).
Unlike corporations treated as S corporations, a corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.
Impact
Since corporations are state entities and the
C corporation status refers to the tax treatment of these corporations
by the federal government, the C corporation's impact is mostly
relegated to the tax realm. The impact of double taxation, the
taxation of the corporation's income and the separate taxation on their
dividends, constitutes the impact of the C corporation treatment.
C corporations are subject to this double taxation unlike S
corporations and most other business entities taxed by the federal
government.
Esquire Corporate Networks can efficiently and
cost-effectively form your corporation in all 50 States as well as in
the District of Columbia. If you have more questions regarding
the choosing of an S or C election, be sure to speak with an attorney,
CPA, or financial advisor.
