An S Corporation or S-Corp, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
In general, S Corporations do not pay any income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.
AN OVERVIEW OF S CORPORATIONS
S corporation provides many of the benefits of partnership taxation and at the same time gives the owners limited liability protection from creditors. The S corporation rules are contained in Subchapter S of the Internal Revenue Code (1361-1379). S status combines the legal environment of C corporations with taxation similar to taxation of partnerships.
S corporations are treated as corporations under state law. They are recognized as separate legal entities and generally provide shareholders with the same liability protection afforded by C corporations. For Federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed. Also, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation.
Unlike C corporation, an S corporation is not eligible for a dividends received deduction
Unlike C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contributions.
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, or a limited liability company).
- Must have only one class of stock.
- Must not have more than 100 shareholders.
- Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
- Shareholders must be U.S. citizens or residents, and must be physical entities (a person), so corporate shareholders and partnerships are to be excluded. However, certain tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
- 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” with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation’s shareholders. If a shareholder resides in a community propertystate, the shareholder’s spouse generally must also sign the 2553.
The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often, the IRS will accept a late S election.
Some states such as New York and New Jersey 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.
The S election affects the treatment of the corporation for Federal income tax purposes. The election does not change the requirements for that corporation for other Federal taxes such as FICA and Federal unemployment taxes.
IRS STUDY OF S CORPORATION REPORTING COMPLIANCE
In 2005, the IRS launched a study to assess the reporting compliance of S corporations. The study began in late 2005 and examined 5,000 randomly selected S corporation returns from tax years 2003 and 2004. 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.
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 the employer and half by the 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 individual to avoid tax penalties, even if this income is “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 continuation of 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).
CONVERSIONS FROM C CORPORATION
S corporations that have previously been C corporations may also, in certain circumstances, pay income taxes on untaxed profits that were generated 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
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.
As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders. Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may re-categorize distributions paid to shareholder-employees as wages if shareholder employees are not paid a reasonable wage for the services they perform in their positions within the company.
FILING FORM 1120S
Form 1120S generally must be filed by March 15th of the year immediately following the calendar year covered by the return or, if a fiscal year (a year ending on the last day of a month other than December) is used, by the 15th day of the third month immediately following the last day of the fiscal year. The corporation must complete a Schedule K-1 for each person who was a shareholder at any time during the tax year and file it with the IRS along with Form 1120S. The second copy of the Schedule K-1 must be mailed to the shareholder.
Some but not all states recognize a state tax law equivalent to an S corporation, so that the S corporation in certain states may be treated the same way for state income tax purposes as it is treated for Federal purposes. A state taxing authority may require that a copy of the Form 1120S return be submitted to the state with the state income tax return.
CALIFORNIA, NEW YORK CITY ADDITIONAL TAXES
S-corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company and 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, low profit-margin businesses, the LLC franchise tax fees may exceed the S corp net income tax.
In New York City, S-corporations are subject to the full corporate income tax at a 8.85% rate. However if the S-corporation can demonstrate that a portion of its business was done outside the city, that portion will not be subject to the additional tax.
Since corporations are state entities and the C corporation status refers to the tax treatment of these corporations by the federal government, the C corporation’s impact is mostly relegated to the tax realm. The impact of double taxation, the taxation of the corporation’s income and the separate taxation on their dividends, constitutes the impact of the C corporation treatment. C corporations are subject to this double taxation unlike S corporations and most other business entities taxed by the federal government.
Diversified Corporate Services can efficiently and cost-effectively form your corporation in all 50 States as well as in the District of Columbia. If you have more questions regarding the choosing of an S or C election, be sure to speak with an attorney, CPA, or financial advisor.
C CORPORATION VS S CORPORATION
The income of a C corporation is taxed, whereas the income of an S corporation (with a few exceptions) is not taxed under the Federal income tax laws. The income, or loss, is applied, Pro Rata, to each Shareholder and appears on their tax return as Schedule E income/(loss).
Unlike corporations treated as S corporations, a corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.
A C corporation or C corp. is a corporation in the United States that, for Federal income tax purposes, is taxed under 26 U.S.C. § 11 and Subchapter C (26 U.S.C. § 301 et seq.) of Chapter 1 of the Internal Revenue Code. Most major companies (and many smaller companies) are treated as C corporations for Federal income tax purposes.