S corporation
In the United States, an S Corporation or "S-Corp" is a form of corporation that meets the IRS requirements to be taxed under Subchapter S of the Internal Revenue Code.
Taxation of S Corporations
Unlike a regular C corporation, an S Corporation generally pays no corporate income taxes on its profits. Instead, the shareholders in the S corporation pay income taxes on their proportionate shares, called distributive shares, of the S corporation's profits. Shareholders pay the tax regardless of whether the S corporation pays out money or not. The FICA tax need only be paid on employee wages and not on distributive shares.
Because FICA tax is avoided 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 their position within the company.
Actual distributions of profits, as opposed to distributive shares, typically have no effect on shareholder tax liability. In other words, a shareholder's pro rata share, or distributive share, of the S corporation's profit is what gets taxed--not the money paid out to the shareholder. 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.
S corporations that have previously been C corporations may also in certain circumstances pay income taxes on profits that were earned when the corporation operated as a C corporation.
Example: Widgets Inc, an S-Corp makes 10,000,000 in net income and is owned 51% by Bob and 49% by John. On Bob's personal tax return, he will report 5,100,000 in income and pay taxes on this income. John will report 4,900,000 of income on his personal 1040 return and pay taxes on this income. If for some reason, Bob (as the majority owner) decides not to distribute the money, both Bob and John will still owe taxes on their distributive shares, even though neither received any cash distribution. (Typically, S corporations use shareholder agreements that stipulate at least enough distribution must be made for shareholders to pay the taxes on their distributive shares.) They will also be required to pay their FICA tax, currently 15.3 percent, on any salary paid, following the rules of the FICA Tax. Keeping it simple, we'll assume they both pay themselves 94,200. Their FICA Tax liability will be 14,412 each. The distribution of the additional profits from the S-Corp will be done FICA Tax-Free. Their total tax savings will be approximately 603,000, or 6.15% of their income minus their salaries.
California Taxation
S-Corps pay a franchise tax of 1.5% of Net Income in the State of California. This should be taken into consideration when deciding on using an LLC versus an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues, will be lower than the 1.5% Net Income tax.
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, a partnership or a single-member or multiple member limited liability company).
- Must not have more than 75 shareholders.[1]
- Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are be excluded.
- Must have only one class of stock.
- Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.
If a corporation meets the foregoing requirements, its shareholders may file Form 2553: "Election by a Small Business Corporation" [2][3] with the 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 must also sign the 2553.
The S corporation election must typically be made within 75 days of the start of the tax year.
Caution: Some states such as New York require a separate state-level S election.
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 75 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.
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