What are the basics of an S Corporation?

An S corporation (S corp for short) is a type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.

An S corp is a corporation with the Subchapter S designation from the IRS. To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which the owner, or “shareholder” are responsible. Nevertheless, liability protection is limited – S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

What makes the S corp different from a traditional corporation (C corp) is that profits and losses can pass through to personal tax returns. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”

What are the specific S Corporation requirements?

  • An incorporated entity
  • Timely filing of Form 2553
  • The entity has no more than 100 shareholders
  • The entity has no nonresident alien shareholders
  • The only shareholders are individuals, deceased individual’s estates, certain exempt organizations (501(c)(3)), or certain trusts
  • The entity has only one class of stock
  • The entity is not one of the following ineligible corporations:  A bank or thrift institution that uses the reserve method of accounting for bad debts under Section 585, an insurance company subject to tax under Subchapter L of the Code., aA corporation that has elected to be treated as a possessions corporation under Section 936 or a domestic international sales corporation (DISC) or former DISC
  • Each shareholder consents to the S corporation election
  • The entity has or will adopt or change to one of the following tax years:
    • A tax year ending December 31;
    • A natural business year;
    • An ownership tax year;
    • A tax year elected under Section 444;
    • A 52-53-week tax year ending with reference to a year listed above; or
    • Any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose

How does S corporation taxation generally work?

An S Corporation is not subject to corporate tax rates. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. Instead, an S Corporation passes through profit (or net losses) to shareholders pro rata. The business profits are taxed at individual tax rates on each shareholder’s Form 1040.

S Corporation’s profits are only taxed once – at the shareholder level. S Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. Regardless of this choice, all profits are treated as if they were distributed to shareholders – they are allocated each year. An S Corporation shareholder might be taxed on income he or she never received in the form a cash, whereas a shareholder of C Corporation is taxed on dividends only when those dividends are actually paid out.

Can different entity types convert to an S corporation?

LLCs can elect to be taxed as S Corporations as long as they follow the rules. The difference between a LLC and S Corporation is not one of entity selection, it is one of tax status selection. Generally investment businesses, businesses that produce losses, and real estate businesses are better served as LLCs. Family enterprises, profitable businesses without financing needs, and businesses that the owners work for are served well as S corporations.

Concerns can arise when a C corporation converts to a S corporation. If S Corporation sells an appreciated asset that appreciated while a C Corporation, that gain, called built-in gain, can be taxed at the highest corporate income tax rates. Built-in gain tax prevents C Corporations from saving income taxes by converting to S Corporation prior to selling appreciated assets.