Forming an S Corporation

Requirements and Tax Benefits of the Small Business Corporation

Feb 10, 2010
Jessie Vanwinkle

Tax Advantages of the S Corporation - Penywise

An S corporation has distinct tax advantages over the C corporation, but it also comes with stricter requirements.

According to the United States Internal Revenue Service, "S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes." An S corporation is formed when the shareholders agree to elect S corporation status with the IRS. This is accomplished through the filing of IRS Form 2553 "Election by a Small Business Corporation." The form must be signed by all of the corporation's shareholders.

What are the Requirements for Forming an S Corporation?

To qualify for S corporation status, the corporation must:

Be a domestic corporation formed in the United States.
Have only "allowable" shareholders, which include individuals, estates and certain trusts.
Have no shareholders that are partnerships, corporations or non-resident aliens.
Have no more than 100 shareholders.
Have only one class of stock.
Not be an "ineligible" corporation. Ineligible corporations include certain financial institutions, insurance companies and domestic international sales corporations.

All shareholders must agree to the designation of the corporation as an S corporation. Shareholders wishing to form an S corporation typically enter into shareholder agreements restricting their ability to transfer shares so that shares are not transferred to someone who is not an "allowable" shareholder. The shareholder agreement should also restrict the transfer of shares in such a manner as to exceed the limit of 100 shareholders.

What are the Tax Advantages of the S Corporation?

With an S corporation, income is not taxed at the corporate level. Rather, income of the corporation is passed through to the shareholders, who then pay income taxes at their appropriate tax rates. Nevertheless, the shareholders must pay tax on income of the corporation whether or not it is distributed. If the income of the corporation is not distributed to shareholders in any given year, they must pay income tax on their pro rata share of the income as if it had been distributed.

The pass-through taxation feature of the S corporation is advantageous to the shareholders in that it allows the income of the corporation to be taxed only one time. By contrast, the C corporation is subject to taxation at its applicable tax rate. After the C corporation pays its income tax, it may then distribute profits to shareholders, who must declare the distributions as income for themselves, subject to taxation. Accordingly, with a C corporation, the corporation's income is subject to double taxation.

S corporation status may also be desirable if the corporation is sustaining losses. If the S corporation loses money, the losses may be passed through to the shareholders. The shareholders may then use these losses to reduce their income, which in turn reduces their tax liability.

Tax Attorneys and Financial Planners

Corporations that meet IRS requirements may elect S corporation status. S corporations are able to avoid the double taxation that burdens C corporations. Because of the tax considerations involved in choosing the appropriate form of business entity, entrepreneurs would be wise to seek the assistance of a tax lawyer and a financial planner before making a decision.

Disclaimer: This article is in no way intended as legal or financial advice. For help with specific legal or financial issues, one should contact an attorney or financial expert in one's local area.