Like a C corporation, an S Corporation, often known as a subchapter S corporation is a separate business entity from the S corporation’s owners for both legal and tax purposes. Unlike C corporations, the IRS has put in place certain restrictions for what types of businesses can be S corporations and limitations on who can be shareholders or members of S Corporations.
(1) S corporations must be domestic corporations; (2) S corporations can only issue one class of stock; (3) the stock of an S Corporation can only be owned by individuals, estates and certain types of trusts; S corporations may not have owners who are partnerships, corporations or non-resident alien shareholders, (4) S corporations may not have more than 100 shareholders; and (4) S corporations may not be an ineligible corporation (i.e. certain financial institutions, insurance companies and domestic international sales corporations). The S corporation business structure is an attractive business form to many small business owners because income and losses can be passed through to individual shareholders of the S corporation and included on a shareholder of an S corporation’s individual tax returns. The pass through nature of an S corporation allows S corporation shareholders to avoid the double taxation that is inherent with a C corporation.
To become an S corporation (for entity and tax purposes) the S corporation shareholders must file as a C corporation, follow all corporate formalities for a C corporation and then make an S election by having all shareholders of the S corporation sign and file Tax Form 2533 with the IRS prior to the first two months and fifteen days of the beginning of the tax year in which the S corporation election is to take effect.
Note that an LLC may also have S corporation tax status, but will remain a limited liability company from a legal standpoint. One of the biggest advantages of S corporation tax status is that while members of an LLC are subject to employment taxes on the entire net income of the business, only the wages of the S corporation shareholder/member who is an employee of the S corporation are subject to employment taxes. The remaining income of the S corporation is paid to the member or shareholder of the S corporation as a distribution from the S corporation, which is generally taxed at a lower tax rate, if taxed at all.
Note that any shareholder or member of an S corporation who works for the S corporation must pay him or herself reasonable compensation for his or her work done in the capacity as an employee of the Corporation. What constitutes a “reasonable salary” for an employee of an S corporation is scrutinized carefully by the IRS. Another benefit of S corporation status is that owners of S corporations that do not have inventory can use the cash method of accounting, which is simpler than the accrual method in that income is taxable when received by the S corporation and expenses are deductible when paid to the S corporation. A business that is thinking about S corporation status should talk to the company’s accountant to determine whether an S corporation tax classification would be beneficial for the business.
