The shareholders of an S Corporation receive the benefit of limited liability, meaning that they cannot normally be held liable for the debts and liabilities of the corporation beyond the value of their shares, but are treated in the manner of partners for purposes of taxation.
To qualify as an S Corporation, in broad terms, the corporation:
- May have no more than 100 shareholders, all of whom are individuals, estates, or qualifying trusts;
- Must have only one class of stock (although differences in voting rights may be allowed);
- Must be formed in the United States; and
- May not be a bank, insurance company or a Domestic International Sales Corporation (DISC).
All shareholders must be citizens or legal residents of the United States. Non-resident aliens may not hold shares in an S Corporation.
Becoming an S Corporation
By default, all corporations are treated as C Corporations. A corporation must elect to be treated as an S Corporation no later than March 15th of the tax year to which the election is to be applied.
All shareholders must sign the form making the S Corporation election. In some states, the shareholders must also elect to be treated as an S Corporation at the state level, in addition to their federal filing.
If the election is made, the corporate profits are passed through to the shareholders, and thus are not subject to corporate taxation.
After the election is made, the corporation will continue as an S Corporation until either it no longer qualifies for that status or a majority of the shareholders vote to revoke that status.
The most significant advantages of converting a sole proprietorship or partnership to an S Corporation are limited liability, and possible tax benefits.
While creditors can reach corporate assets, as a general rule they are not able to reach the assets of the corporation's shareholders.
An S Corporation has elected for pass-through taxation. Thus, in contrast with a C Corporation, its profits are not potentially subject to double-taxation, first as corporate profits and second as personal income when distributed to the shareholders. When opting between an S Corporation and C Corporation, stockholders should consider the impact of paying taxes at the corporate rate as opposed to their personal marginal tax rates.
Corporate losses may ordinarily be passed through to the shareholders, who can then claim a deduction from their other taxable income.
As distributions from an S Corporation are not wages, they are not subject to self-employment tax. However,
- Any salary received by a shareholder as a corporate officer or employee would remain subject to employment taxes.
- Any officer who performs significant tasks for the corporation will likely be regarded by the IRS as an employee, and the IRS may reallocate distributions made to an undercompensated employee-shareholder as wages, with possible consequent late fees, penalties, and interest.
Due to pass-through taxation, shareholder employees of an S Corporation are less likely to be subject to IRS claims of excessive compensation, as compared to shareholder employees of C Corporations.
You should discuss the full financial and tax benefits and consequences of S Corporation status with your accountant, prior to making the election.
Even if eligible, not every corporation is well-served by choosing S status.
- Unlike a C Corporation, the S Corporation may not be the subject of a public offering.
- The shareholders of an S Corporation are limited in the amount they can deduct as a result of business losses, in rough terms to the amount of their basis or investment in the corporation.
- There is no flexibility in allocation of profits: Profits are allocated in proportion to each shareholder's ownership interest in the corporation. As a consequence, some businesses opt instead to form as limited liability companies, in order to take advantage of the greater flexibility in allocation of profits between owners and investors.
- S Corporations may not deduct the cost of fringe benefits granted to employees who have more than a 2% ownership interest in the corporation.
- Businesses that wish to seek foreign investors may be burdened by the residency restrictions on shareholders.
- Shareholders may find themselves subject to the Alternative Minimum Tax (AMT) based upon corporate earnings allocated to them.
Under normal circumstances an S Corporation does not pay corporate income taxes. Instead, the corporate profits are passed through to the shareholders, who report the distribution on their individual tax returns.
Many small business owners whose businesses generate significant profits choose to incorporate as an S Corporation to avoid paying self-employment taxes on all of their income.
The IRS may review the salary that an S Corporation owner chooses to pay himself or herself in order to verify that it is not less than what it would cost to hire an actual employee to perform the same tasks. If the IRS determines that a corporation owner has paid himself an inadequate salary the business owner may be assessed back taxes, fines and penalties.
There are a number of services online that offer salary information for various professions, and those sites can be useful to business owners who want to be sure that they are paying themselves a salary that is reasonable for their location, job and duties.