S CORPORATIONS

Known formally as subchapter S corporations, a name derived from the section of the U.S. tax code dealing with them, S corporations are small business corporations specially designated by the Internal Revenue Service (IRS). They must meet several criteria in order to qualify.

Like all corporations, S corporations are distinct legal entities from their owners, and thus provide limited liability protection to the owners and officers during bankruptcies, lawsuits, and other claims against the company's revenue or assets. The primary advantage that an S corporation has over an ordinary C corporation is that its profits are not taxed separately, at least under federal law, from its owners' personal incomes (some states do not recognize S corporations for purposes of state corporate taxes). By contrast, net profits at C corporations are liable for the federal corporate income tax, which in 1999 ranged from 15 to 35 percent, depending on the amount of net income. Shareholder dividends from C corporations are also taxed as income, leading to double taxation. In exchange for the benefit of escaping the corporate income tax, S corporations are subject to relatively stringent ownership and organization standards set forth by the IRS.

QUALIFYING FOR "S" STATUS

All S corporations start as conventional C corporations, at least for a brief moment in their existence. All corporations are registered in a particular state, usually for a fee, and are governed by the laws of that state; in each additional state where they need to conduct substantive business (e.g., hold bank accounts, hire employees, execute contracts) corporations must also register, or qualify, to do business.

Once a corporation is formed under state law, it may petition the IRS for S status by filing a Form 2553: Election by a Small Business Corporation. The company must show that it meets IRS guidelines. The basic rules to qualify as an S corporation are as follows:

• It can't have more than 75 shareholders (married couples are treated as one).
• Its shareholders must all be individuals or certain kinds of trusts or nonprofit entities (other for-profit corporations generally can't be shareholders).
• It must not be a foreign (non-U.S.) company.
• It can only have one class of stock.
• Its tax year must be on a calendar-year basis unless it can show a business need to do otherwise.
• It can't be involved in certain restricted activities, including some forms of banking, insurance, and international sales.
• It must obtain at least 75 percent of its income from operations or "active" sources rather than passive investments, interest, and so forth, otherwise the excess income from passive sources can be taxed.

There are also restrictions on when a corporation must file in order to gain S status in an intended tax year. Generally, corporations must abide by all of these rules during the entire tenure of their S status, and if they break the rules the IRS may revoke the S privilege. Companies whose S status has terminated may requalify for it if they meet certain criteria. However, the IRS has proven rather equivocal about how strictly some of these must be observed; examples abound of cases in which the IRS ignored the breach of some S corporation rules, particularly when the breach was short-lived.

S CORPORATIONS VS. OTHER
STRUCTURES

Although they are intended for small businesses, S corporations may not be the ideal choice of organization for several reasons. Most importantly, they can be substantially more complex (and in most places more expensive) to operate than partnerships or sole proprietorships. For example, accounting in corporations is usually expected to be much more rigorous than in other business structures. In addition, corporations must pay state registration and renewal fees, and in some states they are not exempt from a state corporate tax. Fulfilling such obligations adds to the cost of doing business and may require the assistance of an accountant or an attorney. As a result, small business owners may find that the protections and tax savings an S corporation provides in theory are not compelling or even practical reasons to justify their legal complexity.

The popularity of S corporations has ebbed and flowed to some degree with the vagaries of tax legislation. For example, after the sweeping 1986 tax code revisions, which established the S corporation in its present form, S status was popular because the highest tax bracket for individuals was lower than that for corporations. Thus, by passing their profits through the S corporation as personal income, high-income business owners could shave a few percentage points off their effective tax burdens. In 1993, however, another tweaking of the federal tax laws tipped the scale in the other direction: the maximum personal income tax became nearly five points higher than the maximum corporate tax. Subsequent reforms in the mid-1990s made S corporations more versatile for other purposes, such as allowing retirement plans and charitable organizations to be shareholders.

The utility of S corporations has also been affected by the rising popularity of some non-corporate, or perhaps semi-corporate, business structure alternatives, especially limited liability partnerships (LLPs) and limited liability companies (LLCs). The latter, in particular, can serve a similar tax-sheltering function to an S corporation, but LLCs aren't subject to as many restrictions. Under some circumstances both LLPs and LLCs can also be taxed as corporations. Both forms first gained widespread acceptance in the 1990s.