S Corporation
Overview
 
An S corporation, for United States federal income tax
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...

 purposes, is a corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

 that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...

.

In general, S corporations do not pay any federal 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.
S corporation status provides many of the benefits of partnership taxation and at the same time gives the owners limited liability protection from creditors.
Encyclopedia
An S corporation, for United States federal income tax
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...

 purposes, is a corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

 that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...

.

In general, S corporations do not pay any federal 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 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 not 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
Dividends received deduction
The dividends-received deduction , under U.S. federal income tax law, is a tax deduction received by a corporation on the dividends paid to it by other corporations in which it has an ownership stake.-Impact:...

.

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
    Limited liability company
    A limited liability company is a flexible form of enterprise that blends elements of partnership and corporate structures. It is a legal form of company that provides limited liability to its owners in the vast majority of United States jurisdictions...

     which has elected to be taxed as a corporation).
  • 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(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
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...

 (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property
Community property
Community property is a marital property regime that originated in civil law jurisdictions and is now also found in some common law jurisdictions...

 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
Passive income
Passive income is an income received on a regular basis, with little effort required to maintain it.The American Internal Revenue Service categorizes income into three broad types, active income, passive income, and portfolio income...

 for three consecutive years when the corporation has accumulated earnings and profits, the S corporation will automatically lose its subchapter S status and revert to being a regular C corporation.http://www.taxalmanac.org/index.php/Sec._1362._Election%3B_revocation%3B_termination

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.

For example, if an S corporation that was formerly a C corporation
C corporation
C corporation refers to any corporation that, under United States income tax law, is taxed separately from its owners. It is distinguished from an S corporation, which is not taxed separately. Most major companies are treated as C corporations for U.S. income tax purposes.-C corporation vs...

 sells an appreciated asset (such as real estate) and the appreciation occurred during the time the corporation was a C corporation
C corporation
C corporation refers to any corporation that, under United States income tax law, is taxed separately from its owners. It is distinguished from an S corporation, which is not taxed separately. Most major companies are treated as C corporations for U.S. income tax purposes.-C corporation vs...

, the S corporation will probably pay C corporation
C corporation
C corporation refers to any corporation that, under United States income tax law, is taxed separately from its owners. It is distinguished from an S corporation, which is not taxed separately. Most major companies are treated as C corporations for U.S. income tax purposes.-C corporation vs...

 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
American Recovery and Reinvestment Act of 2009
The American Recovery and Reinvestment Act of 2009, abbreviated ARRA and commonly referred to as the Stimulus or The Recovery Act, is an economic stimulus package enacted by the 111th United States Congress in February 2009 and signed into law on February 17, 2009, by President Barack Obama.To...

 reduced that 10-year recognition period to 7 years (if that 7th year precedes either 2009 or 2010.) The Small Business Jobs Act of 2010 further reduced the recognition period to 5 years.

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
Social Security Wage Base
For the Old Age, Survivors and Disability Insurance tax or Social Security tax, the Social Security Wage Base is the maximum earned gross income or upper threshold on which a wage earner's Social Security tax may be imposed...

 for 2006, after which no further Social Security tax is owed).

Employee salaries are subject to FICA tax (Social Security & Medicare tax) --currently 13.3 percent--(4.2% Social Security paid by the employee; 6.2% Social Security paid by the employer; 1.45% employee medicare and 1.45% employer medicare). The distribution of the additional profits from the S corporation will be done without any further FICA tax liability.

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
Pro-rata
Pro rata is an adverb or adjective, meaning in proportion. The term is used in many legal and economic contexts. It is sometimes spelled pro-rata, but this is technically a misspelling of the Latin phrase...

 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".

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
California
California is a state located on the West Coast of the United States. It is by far the most populous U.S. state, and the third-largest by land area...

 (minimum $800). This is one factor to be taken into consideration when choosing between a limited liability company
Limited liability company
A limited liability company is a flexible form of enterprise that blends elements of partnership and corporate structures. It is a legal form of company that provides limited liability to its owners in the vast majority of United States jurisdictions...

and an S corporation in California. For highly profitable enterprises, the LLC franchise tax fees (minimum $800), which are based on gross revenues, may be lower than the 1.5% net income tax. Conversely, for high-gross-revenue, low-profit-margin businesses, the LLC franchise tax fees may exceed the S corporation 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.

External links

The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
x
OK