An
S corporation, 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. This
concept is called
single taxation; if the corporation is
taxed as a
C Corporation, it will face
double taxation, meaning both the corporation's profits,
and the shareholders' dividends, will be taxed.
An overview of S corporations
S corporation status 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 Chapter 1 of the Internal Revenue Code (sections
1361 through 1379). S status combines the legal environment of C
corporations with U.S. federal income taxation similar to that of
partnerships.
Like a C corporation, an S corporation is generally a corporation
under the law of the state in which the entity is organized. S
corporations are separate legal entities from their shareholders
and, under state laws, generally provide their shareholders with
the same liability protection afforded to the shareholders of 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 a C corporation, an S corporation is not eligible for a
dividends received
deduction.
Unlike a C corporation, an S corporation is not subject to the 10
percent of taxable income limitation applicable to charitable
contribution deductions.
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
natural persons, so corporate shareholders and partnerships are
generally excluded. However, certain trusts, estates, and
tax-exempt corporations, notably 501
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 property state, 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.
Furthermore, if more than 25% of a S-corporation's gross receipts
consists of passive income for three consecutive years when the
corporation has accumulated earnings and profits, the S corporation
will automatically lose it's subchapter S status and revert to
being a regular C corporation.
[172133]
Taxation issues
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.
FICA
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 recategorize 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.
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.
Conversion 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 now 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 (starting from the first day of the first tax
year of conversion to S-Corp status.)The
American Recovery
and Reinvestment Act of 2009 reduces that 10-year recognition
period to 7 years (if that 7th year preceeds either 2009 or
2010.)
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 ["grossing up" the
$94,200 salary for the 7.65% employer FICA tax for each employee,
using the factor 1.0765] times 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).
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.
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.
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