For many small businesses, the S corporation is the
business entity of choice. The "S" in S corporation refers to a tax
designation. All corporations are created the same way under state law. A small
business must then chose a tax status, to wit, C, S or non-profit.
S corporations are akin to LLCs in that they provide owners
with limited liability protection while offering the tax structure of a
partnership.
An S corporation is a regular corporation that has elected
"S corporation" tax status. Forming an S corporation lets you enjoy
the limited liability of a corporate shareholder but pay income taxes as if you
were a sole proprietor or a partner.
In a C corporation also known as regular corporation, the
company itself is taxed on business profits. The owners pay individual income
tax only on money - they receive from - the corporation as salary,
bonuses, or dividends.
In contrast, in an S corporation, all business profits
"pass through" to the owners, who report them on their personal tax
returns (as in sole proprietorships, partnerships, and LLCs).
Even though an S
corporation with more than one owner must file an informational tax return like
a partnership or LLC, to report each shareholder's portion of the corporate
income, the S corporation itself does not pay any income tax.
When taxing S corporation, most states follow the federal
pattern: They don't impose a corporate tax, choosing instead to tax the
business's profits on the shareholders' personal tax returns.
However, similar to a regular corporation, about half a
dozen states tax S corporation. The tax division of your state treasury
department can tell you how S corporations are taxed in your state.
Fortunately, it isn't a permanent decision to elect to be an
S corporation. If your business later becomes more profitable and you find
there are tax advantages to being a regular corporation, you can drop your S
corporation status after a certain amount of time.
Given below are the advantages of a company being an S
corporation.
- S
corporation shareholders are not subject to self-employment taxes (active
LLC owners are). These taxes, which add up to more than 15% of your
income, are used to pay your Social Security and Medicare taxes.
- Forming
an S corporation normally allows you to pass business losses through to
your personal income tax return, where you can use it to offset
any income that you (and your spouse, if you're married) have from other
sources.
- When
you sell your S corporation, your taxable gain on the sale of the business
can be less than it would have been had you operated the business as a
regular corporation.
Aside from the advantages, S corporations impose strict
requirements. Here are the main rules:
- An S
corporation shareholder may not deduct corporate losses that exceed his or
her "basis" in corporate stock -- which equals the amount
of the shareholder's investment in the company plus or minus a few
adjustments.
- S
corporations may not deduct the cost of fringe benefits provided to
employee-shareholders who own more than 2% of the corporation.
- Each S
corporation shareholder must be a U.S.
citizen or resident.
- S
corporations may not have more than 100 shareholders.
- S
corporation profits and losses may be allocated only in proportion to each
shareholder's interest in the business.
To create an S corporation, you must first create a regular
corporation by filing articles of incorporation with your secretary of state's
office or your state's corporations division. Then, to be treated as an S
corporation, all shareholders must sign and file IRS Form 2553.
You can get the benefits of limited liability and
pass-through taxation by creating a limited liability company (LLC). Because an
LLC offers its owners the significant advantage of greater flexibility in
allocating profits and losses, and because LLCs aren't subject to the many
restrictions of S corporations, forming an LLC is often the better choice.
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