S corporation

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An S corporation or S-corp, for US federal tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

Unlike a regular C corporation, an S corporation generally pays no corporate income taxes on its profits. Instead, the shareholders in the S corporation pay income taxes on their proportionate shares, called distributive shares, of the S corporation's profits. Shareholders must report the income (and pay a related tax, if any) regardless of whether the shareholders receive distributions from the S corporation.

1 Qualification for S corporation status
2 Taxation issues
3 References
4 See also
5 External links

[edit] 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, a partnership or a single-member or multiple member limited liability company).
Must not have more than 100 shareholders.^[1]^[2]
Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are to be excluded.
Must have only one class of stock.
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" ^[3]^[4] with the IRS within 75 days of the first tax year. The 2553 form 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 within two months and fifteen days after the beginning of the tax year for which the election is to take effect, or at any time during the year immediately preceding the tax year for which the election is to take effect. However, Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often times, the IRS will accept a late S election.

Some states such as New York 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.

[edit] Taxation issues

[edit] FICA

The FICA tax need only be paid on employee wages and not on distributive shares. Because FICA tax is avoided on distributive shares, the IRS and equivalent state revenue agencies may recategorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for their position within the company.

[edit] 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.

[edit] Conversion from C corporation

S corporations that have previously been C corporations may also, in certain circumstances, pay income taxes on profits that were realized 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.

[edit] 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 both the employer and 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 indivudal to avoid tax penalties. Even if "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 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).

[edit] IRS Study of S Corporation Reporting Compliance

In 2005, the IRS launched a study to assess the reporting compliance of S corporations^[5]. The study will examine 5,000 randomly selected S corporation returns from tax years 2003 and 2004, with audits expected to begin in late 2005. 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.

[edit] California state taxes

S-corps pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This should be taken into consideration when deciding on using an LLC versus 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 businesses, the LLC franchise tax fees may exceed the S corp net income tax.