An S corporation is different from a regular (or C) corporation only in that it elects to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code of the IRS. Congress created Subchapter S in the tax code in 1958 to promote entrepreneurship and small businesses. S corporations combine the benefits of partnerships (single taxation) with the limited liability offered by corporations. C corporations, on the other hand, allow for more flexibility in the number and type of shareholders, as well as different classes of stock.
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).
- Must have only one class of stock. (See Common Stock vs Preferred 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 physical entities (a person), so corporate shareholders and partnerships are to be excluded. However, certain 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 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.
For both S and C corporations, the formation typically requires a state filing, obtaining a Federal Tax ID and an S election. The state filing typically consists of:
- Articles of Incorporation
- Corporate Bylaws
- Written consent of incorporator
- Resolutions of the first meeting of the Board of Directors
If a corporation meets the requirements of S corporation status 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 (IRS). 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. 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.
Taxation of a C corporation vs. S corp
While employee Medicare and FICA taxes, as well as state taxes are not affected by a company's corporate structure, federal income tax treatments are different for C and S corporations. The corporate tax rate is usually lower than the personal income tax rate. However, in the case of C corporations, there is double taxation because (a.) The corporation is taxed on profits, and (b) when these profits are distributed to shareholders (owners), the owners are taxed on these dividends.
S corporations can bypass this double taxation by reporting the entire income on the personal income tax returns of the shareholders. This is done in proportion to the ownership of each shareholder in the company. Not only does this allow bypassing double taxation, it also means that the losses incurred by the company can be reported on the shareholders' personal income tax return, thereby reducing their tax liability. C corporations carry their losses forward to offset them against future profits of the company.
Differences in Tax Reporting
For S corporations, shareholders report income on Form 1120S, Salaries on Form W-2 and Profit distribution on Schedule K-1. For a C corporation, tax reporting is on Form 1120 for income, Salaries on Form W-2 and Profit distribution on Form 1099-DIV.