S corporation
An S corporation, for United States federal income tax, is a closely held 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 and 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.
Overview
S corporations are ordinary business corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.The term "S corporation" means a "small business corporation" which has made an election under § 1362 to be taxed as an S corporation.
The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code. Congress, acting on the Department of Treasury's suggestion of 1946, created this chapter in 1958 as part of a larger package of miscellaneous tax items. S status combines the legal environment of C corporations with U.S. federal income taxation similar to 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.
S corporations vs. C corporations
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. However, with modern incorporation statutes making the establishment of a corporation relatively easy, firms that might traditionally have been run as partnerships or sole proprietorships are often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form; this is particularly true of firms established prior to the advent of the modern limited liability company. Therefore, taxation of S corporations resembles that of partnerships.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.
Eligibility
A corporation is "eligible" if it:- Has no more than 100 shareholders,
- Has shareholders who are all individuals
- Has no nonresident aliens as shareholders, and
- Has only one class of stock.
Shareholder requirements
Shareholders must be U.S. citizens or residents, and must be natural persons, so corporations and partnerships are ineligible shareholders. However, certain trusts, estates, and tax-exempt corporations, notably 501 corporations, are permitted to be shareholders. An S corporation may be a shareholder in another, subsidiary S corporation if the first S corporation owns 100% of the stock of the subsidiary corporation, and an election is made to treat the subsidiary corporation as a "qualified subchapter S subsidiary". After the election is made, the subsidiary corporation is not treated as a separate corporation for tax purposes, and all "assets, liabilities, and items of income, deduction, and credit" of the QSub are treated belonging to the parent S corporation.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.
Stock requirements
An S corporation may only have one class of stock. A single class of stock means that all outstanding shares of stock confer "identical rights to distribution and liquidation proceeds," i.e. profits and losses are allocated to shareholders proportionately to each one's interest in the business. § 1.1361-1. Differences in voting rights are disregarded, which means that an S corporation may have voting and nonvoting stock.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. 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.
If a corporation that has elected to be treated as an S corporation ceases to meet the requirements, the corporation will lose its S corporation status and revert to being a regular C corporation.
An S corporation's election will also terminate if, for each of three consecutive years, its passive investment income exceeds 25% of gross receipts and it has accumulated earnings and profits. § 1362. An S corporation will only have accumulated earnings and profits if it was a C corporation at some time, or acquired or merged with a C corporation.
Taxation
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.Distributions
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.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.
Quarterly estimated taxes must be paid by the individual to avoid tax penalties, even if this income is "phantom income".
Example
Widgets Inc, an S-Corp, makes $10,000,000 in net income in 2006 and is owned 51% by Bob and 49% by John. Keeping it simple, Bob and John both draw salaries of $94,200.Employee salaries are subject to FICA tax --currently 15.3 percent--. The distribution of the additional profits from the S corporation will be done without any further FICA tax liability.
If for some reason, Bob 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.
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 sells an appreciated asset 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 tax rate is 35% on the appreciated property, but is only realized if the BIG property is sold within 10 years The American Recovery and Reinvestment Act of 2009 reduced that 10-year recognition period to 7 years The Small Business Jobs Act of 2010 further reduced the recognition period to 5 years.
Federal tax
Taxable Income to Shareholders
If a shareholder owns more than 2% of the outstanding stock, amounts paid for group health insurance for that shareholder are included on their W-2 as "wages." The same applies to amounts contributed to Health Savings Accounts.Filing Form 1120S
Form 1120S generally must be filed by March 15 of the year immediately following the calendar year covered by the return or, if a fiscal year 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.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.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.State tax
States impose tax laws and regulations for corporate income and distributions, some of which may be directed specifically at S Corporations. 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.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.