What is an S Corporation?

WHAT IS AN S CORP AND IS IT RIGHT FOR YOUR BUSINESS?

An S corporation is established under state law. To be an S Corporation, the entity must qualify under Subchapter S of the Internal Revenue Code. These Code sections provide that the S Corporation is not taxed as a corporation for federal income tax purposes. The tax laws regarding S corporations are complex. It is important to discuss the advantages and disadvantages of an S Corporation with your accountant.

An S corporation provides that stockholders have limited liability for corporate obligations. And, an S corporation is taxed in the same manner as a partnership, rather than a corporation. There are rarely any federal income taxes at the corporate level for S corporations. Profits or losses from S corporations flow directly through the company to the shareholders. This avoids double taxation.

In addition, losses from S corporations are applied as direct tax deductions against other income. There are limitations on deductions for those shareholders considered to be passive investors in the S Corporation. The sad news is that stockholders of S corporations are taxed on the net profits and gains of the corporation even if they do not receive any dividends from the corporation. On the bright side, dividends paid by S corporations generally are not taxable to the stockholders because profits have already been taxed. There are limitations. To qualify for an S Corporation election, the business must be a domestic corporation, have no more than 75 shareholders, and have only certain classes of eligible shareholders. This means that C corporations, partnerships, LLCs, and trusts cannot be shareholders of an S corp. All stockholders must consent to an S corporation election. However, the S Corporation election can be revoked by shareholders. After an election is revoked, the S Corporation must wait five years before it can elect to be an S Corporation once again.

An S corporation has only one class of stock. It is possible however, to have one class of stock with different voting rights, for example, voting and nonvoting common stock. An S corporation has a continuing obligation to meet these conditions. Otherwise, the S election is terminated and the corporation is taxed as a C corporation.

Fringe benefits (medical insurance, medical reimbursement plans, disability income plans, group term life insurance) paid to stockholders owning more than two percent of company stock cannot be deducted by the corporation. Health insurance premiums can be deducted by the owner-employee in the same way that self-employed individuals can deduct these expenses.

This article is for information only. Please discuss your particular situation with a qualified attorney and your tax advisor.

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