How S Corporations are Taxed

Understanding S Corporation Taxation

The major difference between the tax structure for a C corporation, and an S corporation, is how profits are taxed. In reality, an S corporation is not actually a separate type of corporation; it is simply a tax status choice that the owners make when they want to avoid two-tiered corporate taxation.

It used to be that an S corporation was the only choice if your goal was to protect your personal assets from business claims while still having business profits taxed on your individual tax return. Now many states, including Delaware, have a fairly new type of business structure called a limited liability company, or LLC. We have other articles that discuss the LLC, so let's stay focused on the S corporation for now.

Understanding the S Corporation Election

An S corporation is a regular corporation that has elected "S corporation" tax status. An S corporation provides the limited liability protection of a C corporation, but enables you to pay income taxes on the same basis as a sole proprietor or a partner.

As we discussed in our articles on regular, or C corporations, a regular corporation is taxed on business profits. The corporation's owners pay individual income tax on money that they draw from the corporation as salary, bonuses or dividends. The corporation itself pays taxes for its profits and retained earnings.

With an S corporation, all business profits pass through to the owners, who report them on their personal tax returns just like sole proprietorships, partnerships and LLCs. Although the S corporation itself does not pay any income taxes, if there are multiple owners then the corporation must file an informational tax return in order to tell the IRS what each shareholder's portion of the corporate income is.

Understanding S Corporation Requirements

There are certain mandatory requirements that must be met before you can elect S corporation status. Here is a summary of those requirements:

• All shareholders must be U.S. Citizens or residents.
• S corporation profits and losses must be allocated only in proportion to each. shareholder's investment in the business.
• S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

This is only a quick overview. Be sure to check with your accountant and attorney,for the most complete and up-to-date information.

The decision to elect S corporation status isn't permanent. As your business grows, you may find that it is more advantageous to change your tax status to that of a general corporation. The IRS provides for the ability to change your tax status according to certain time frames each year.

Understanding the S Corporation Election Process

If you meet all of the requirements for S corporation status, then choosing this election is as simple as having all shareholders sign and file IRS Form 2553. This form must be completed shortly after the corporation is formed, or at the beginning of each subsequent fiscal year.

Understanding S Corporation Alternatives

As we mentioned earlier, you can also achieve the goals of an S corporation by choosing to organize your company as an LLC. You can accomplish the simultaneous goals of limited liability and pass-through taxation by creating a limited liability company (LLC). Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and because LLCs aren't subject to the many restrictions of S corporations, forming an LLC is often the better choice. (To learn more about limited liability companies, see "LLC Basics.")

In Summary

Nothing in this article should be construed as legal tax advice. The author is not an accountant or financial advisor. There is no substitute for receiving professional tax and legal advice from your accountant and attorney.