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What is an S Corporation?

S Corporation

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S Corporation

An S corporation, often abbreviated as “S corp,” is a type of corporation in the United States that meets specific Internal Revenue Service (IRS) criteria, allowing its income, losses, deductions, and credits to pass through to its shareholders for federal tax purposes. This “pass-through” taxation means that the corporation itself is not subject to federal income tax. Instead, the shareholders report the corporation’s income and losses on their own individual tax returns.

Here are some key features and characteristics of an S corporation:

  • Pass-through Taxation: The primary attraction of the S corporation is its ability to avoid double taxation. Unlike a traditional C corporation, which gets taxed at the corporate level and then shareholders pay taxes on dividends, the S corp’s income is passed through to the shareholders and is only taxed at that level.
  • Eligibility Restrictions:
    • Can have no more than 100 shareholders.
    • Shareholders must be U.S. citizens or resident aliens.
    • Can have only one class of stock (though there can be differences in voting rights).
    • Certain types of businesses, like certain financial institutions and insurance companies, cannot be S corporations.
  • Liability Protection: Shareholders enjoy limited liability protection, similar to the protection offered by C corporations. This means shareholders are generally not personally responsible for the corporation’s debts or liabilities.
  • State Taxation: Although the federal government may not tax the S corp at the corporate level, some states might. It’s essential to check state tax regulations.
  • No Accumulated Earnings Tax or Personal Holding Company Penalty: These are two tax penalties that can impact C corporations but not S corporations.
  • Shareholder Wages: Shareholders who work in the business are often paid both a wage (on which payroll taxes are due) and distributions. This has been a point of contention with the IRS, as some try to minimize wages to reduce payroll taxes. The IRS expects shareholders to be paid a “reasonable” wage for their work before taking distributions.
  • Formation and Maintenance: An S corporation starts as a general corporation. After the corporation has been formed, it may elect S corporation status by submitting Form 2553 to the IRS. This election must be made by a certain deadline to be valid for the desired tax year. Regular corporate formalities, such as holding annual meetings and keeping minutes, still apply to S corporations.

If you’re considering forming an S corporation or any other business entity, it’s crucial to consult with legal and tax professionals to ensure you’re making the best choice for your specific situation.

Example of an S Corporation

Jane and John decide to start a software development business together. They want to protect their personal assets and take advantage of pass-through taxation, so they consider forming an S corporation.

  • Formation:
    • They first create a corporation in their home state by filing Articles of Incorporation and paying the required fees.
    • After forming the corporation, they apply for an Employer Identification Number (EIN) from the IRS.
    • They then file IRS Form 2553 to elect S corporation status. All shareholders (in this case, both Jane and John) must sign the form.
  • Operating the S Corp:
    • The business does well in its first year, earning a net profit of $200,000.
    • Jane and John decide to each take a “reasonable” salary of $50,000 for their work in the business. This total payroll expense of $100,000 is deducted from the company’s net profit.
    • After their salaries, the company’s adjusted net profit is $100,000. This amount is passed through to Jane and John equally, as they are 50/50 shareholders. They each receive $50,000 in distributions.
  • Tax Implications:
    • Jane and John each pay personal income taxes on their $50,000 salaries, plus the additional $50,000 they each receive in distributions (totaling $100,000 income each).
    • The S corp itself does not pay federal income taxes on its profits. However, it must still file an informational tax return (Form 1120S) to report its financial activities to the IRS.
    • Jane and John also pay Social Security and Medicare taxes on their salaries, but not on their distributions, potentially saving them on self-employment taxes.
  • Asset Protection:
    • In the unfortunate event that the company faces a lawsuit, Jane and John’s personal assets (like their homes, cars, and personal savings) are generally shielded from any corporate liabilities due to the limited liability protections offered by the corporate entity.

This example simplifies many aspects of running an S corporation, but it provides a general overview of the benefits and structure of such an entity. Again, real-world situations can be more complex, and it’s crucial to consult with professionals when making decisions related to business formation and taxation.

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