A small business has the option of incorporating at the beginning of its existence or after years of doing business. Once it incorporates, it has two choices: to be a regular C corporation by default or to elect S corporation status, a name derived from Subchapter S of the Internal Revenue Code. This status was derived in an effort to make incorporating more attractive to small businesses and allow them to enjoy some of the benefits of corporate status while avoiding some of the drawbacks. While most small businesses are eligible for S status, there are some requirements that must be met, such as limitations on the number and kind of stockholders the corporation may have.
In Choosing a Legal Structure for Your Business , Stuart Handmaker explains that "Essentially, there isn't any difference between a C corporation and an S corporation. Each of them is a corporation, and each one has the same characteristics, shareholders, directors, officers, records, minute books, problems, and the like. The only real difference is that the S corporation has filed a special form with the Internal Revenue Service stating that it wants to be an S corporation."
What makes the S corporation different from the C corporation, then, is that it has special status in the eyes of the IRS. In short, the S corporation is viewed as a partnership or sole proprietorship for taxation purposes. This means that the corporation itself is not taxed, as C corporations are; rather the S corporation's profits are passed on to its shareholders, who pay income tax on that money. In nearly all other respects, though, the S corporation is essentially the same as the C corporation. Most importantly, S corporations receive the benefit of limited liability that goes along with being a corporation. The combined benefits of limited liability (the lack of which is the main drawback of partnerships or sole proprietorships) and avoidance of double taxation (the main drawback of C corporations) makes the S corporation the most popular legal structure amongst small business owners.
FILING WITH THE INTERNAL REVENUE SERVICE Once a business has gone through the procedure of becoming a corporation by filing the articles of incorporation, etc., it can elect S corporation status by filing form 2553 with the IRS. All of the corporation's shareholders must sign this form or file special shareholder consent forms. These rules apply to anyone who has held stock in the company during the current tax year. To be eligible for S corporation status for the current tax year, a corporation must file the form by the fifteenth day of the third month of the corporation's tax year. Once the form has been filed, it is not necessary to file every year.
ELIGIBILITY For a corporation to be eligible for S corporation status, the following conditions must be met and maintained:
INELIGIBLE BUSINESSES Those businesses that are ineligible for S corporation status include:
LIMITED LIABILITY Like C corporations, S corporations are considered to be separate entities apart from their owners for all purposes except taxation. This means that debts incurred by the corporation are the responsibility of the corporation, not its shareholders, who can only be held accountable up to the amount they invested in the corporation. If the corporation does not possess enough assets to pay its debts, the shareholders will not be required to make up the difference out of their own pockets. In addition, if the corporation is sued, liability rests on the shoulders of the corporation, not its shareholders.
AVOIDING DOUBLE TAXATION According to the Internal Revenue Service, an S corporation is not a separate taxable entity. Instead, the corporation's profits are considered to be the shareholders' income (whether the money is distributed or not). Therefore, the corporation's earnings turn up on the shareholders' personal federal tax returns, the amount of which must be proportional to their share of stock. This can be a beneficial arrangement for many small businesses, because the money is taxed only once on the federal level. (State and local taxes may still be levied against the corporation.)
C corporations, on the other hand, are required to pay a federal corporate tax on all profits, and then the shareholders must pay income taxes on their share of dividends that are distributed once the corporation tax has been deducted. In essence, then, that money has been taxed twice. In the case of businesses that intend to leave most of the profits in the corporation or reinvest significant portions of the profits back into the business, though, C corporation status may be preferential if the corporate tax bracket is lower that your personal tax rate. But for companies that plan to pay shareholders all or most of the profits, S corporation status helps them avoid double taxation.
Professional corporations may also desire to elect S corporation status as they are often taxed at a higher rate than a regular C corporation. In addition, corporations that plan to conduct business in more than one state will find it easier to register to do so as an S corporation than as a C corporation. In the case of asset liquidation, S corporation status can also be a benefit because the appreciated value is taxed only on the shareholders' personal income tax. In the case of C corporations, the sale of appreciated assets can result in double taxation because the profit is taxed to the corporation and then to the shareholders to whom it is distributed.
LOSSES AS PERSONAL DEDUCTIONS When an S corporation ends the year with a loss, that loss appears on the shareholders' personal income tax returns, just like profits do. This can mean substantial savings for shareholders, who will end up owing less (or even no) taxes after they deduct their share of the corporation's loss (proportional to their share of stock). In fact, many new small businesses that expect to start off with a loss elect S status so that they will receive this tax credit.
RECORDKEEPING AND ATTENTION TO DETAIL Because an S corporation is still a corporation, it requires owners to pay careful attention to the details of recordkeeping. In some cases, businesses that did file for S corporation status have not been viewed as such by the courts because they failed to act like corporations. In other words, some small businesses simply apply for the status in hopes of gaining limited liability protection, but they fail to keep separate personal and corporate accounts, for example, or to hold regular director's and shareholders' meetings and take minutes, all of which are requirements for corporations. They may also neglect to change their name to reflect their new corporate status in an effort to avoid the extra cost of ordering new stationary and business cards and changing their sign. As a result, the owners of such companies have been known to be found personally liable just as if their business was a sole proprietorship or partnership.
Simply filing the articles of incorporation does not guarantee limited liability. Moreover, an S corporation may be reverted to C corporation status if it fails to continually meet the eligibility requirements, another factor which requires attention to detail. The sale of stock to one foreign investor, for example, could mean the termination of S corporation status, and once a corporation reverts to C corporation status, it is not eligible to file for S status for another five years. This could be a costly error. Simply filing for S corporation status, therefore, does not guarantee protection from double taxation.
DOUBLE TAXATION FOR COMPANIES SWITCHING FROM C STATUS Businesses that start out as C corporations and change their status to that of S corporations may still be taxed as corporations if certain conditions exist. Corporations switching status from C to S and possessing capital gains, excessive passive investment gains, investment tax credits, or liquidations may be still be subject to double taxation.
FRINGE BENEFITS Unlike C corporations—but like partnerships—S corporations are not allowed to deduct fringe benefits given to shareholders who are employees as a business expense. As a result, shareholder-employees must pay taxes on those benefits. These rules apply to all shareholders who own more than two percent of the corporation's stock and are employees of the corporation. All non-shareholder employees, though, may receive benefits without paying taxes.
STOCK LIMITATIONS To remain eligible for S corporation status, a corporation is only allowed to issue one class of stock, which may be a deterrent to businesses that would like to issue preferred as well as common stock. In addition, a limit of 75 stockholders is placed on the S corporation, and all stockholders must be individuals who reside in or are citizens of the United States. The small business corporation, therefore, is denied the benefit of foreign investors in an increasingly global business world.
It is possible for an S corporation to voluntarily revoke its status if it finds that S status is no longer beneficial, or to lose the status involuntarily. In the first case, a majority of the stockholders is required to make the decision, and a simple notification to the IRS is all that is required. In the second case, any act which disqualifies the corporation's eligibility for S status will result in the termination of that status effective on the date that the infraction occurs. In either case, the corporation becomes a C corporation in the absence of S corporation status.
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