S Corporations – an Alternative Approach to Taxation

This is a very good question and one to certainly consider when incorporating. If and when you decide to incorporate, or if you are incorporated, but not as an S Corporation, you should be aware of the benefits of S Corporation status. An S Corporation has significant advantages over “regular” (i.e., “C”) corporations.

Avoidance of Double Taxation

An S Corporation is essentially an alternative approach to taxation of business income. A corporation becomes an S Corporation by electing to be taxed under Subchapter S of the Internal Revenue Code.

S Corporations are taxed like partnerships. There is no tax on the corporation’s income at the corporate level as there is with regular corporations; instead, each item of income and expense of the corporation is passed through to the shareholders for taxation at the shareholder level. Regular corporations’ profits are taxed twice: once at the corporate level and again when profits are distributed as dividends to their shareholders. S Corporation owners receive the advantages of the corporate form (limited personal liability, centralized management, and others) while simultaneously avoiding the double taxation of corporation profits incurred by regular corporations.

S Corporations also avoid the double taxation of liquidating sales or distributions of corporate assets. Regular corporations are taxed both on the gain from the sale of assets and on the distribution of those sales proceeds to their shareholders.

Pass-Through of Losses to Shareholders

All ordinary losses passed through to the S Corporation’s shareholders can be used to offset the shareholders’ other taxable income (subject to certain limitations, i.e. basis at-risk and passive loss limitations). This makes an S Corporation extremely attractive for new businesses because new businesses frequently generate operating losses. Conversely, if your business is profitable, the corporation’s taxable earnings will be passed through to your shareholders and taxed only once.

S Corporation shareholders can write off their share of their corporation’s operating losses against their income only to the extent of their investment in shares or loans to the corporation. While losses in excess of a shareholder’s investment in shares and loans to the corporation cannot be deducted currently, they can be carried forward to future tax years and applied against any profits earned by the corporation or against additional investments made by the shareholders.

This raises an important point. S Corporation shareholders must have sufficient basis in their shares against which to deduct whatever losses they will be allocated. To use an S Corporation’s losses as a write-off against your other income, you must be sure to contribute sufficient capital and loans to the corporation to cover its potential operating losses.

Limited Liability, Centralized Management

S Corporations limit personal liability of the corporation’s shareholders. Partners in a general partnership do not posses this liability protection, nor do partners in limited partnerships if they take an active role in the partnership’s business. S Corporation owners also possess the centralized management and control of corporations. General partners all possess an equal say in the management of the partnership, while limited partners normally have no say whatsoever. S Corporation shareholders, while taxed as partners, are free to arrange their management structure in any way they deem appropriate.

Requirements for Becoming an S Corporation

Only certain entities may be an S Corporation, and they cannot have more than 75 shareholders (husbands and wives are counted as one shareholder). All shares must be owned by individuals, estates, or certain kinds of trusts. Corporations, partnerships, and non- resident aliens may not be S Corporation shareholders. S Corporations can have only one class of stock outstanding, to ensure that each shareholder has the same rights to share in the profits and assets of the corporation, both in dividends and on liquidation. This single class of stock limitation, however, does not prohibit some shares to have greater voting rights than others.

To be an S Corporation, you must file an election with the Internal Revenue Service. The S Corporation election form requires the written consent of all existing shareholders of the corporation and any persons who were shareholders earlier in the year. S Corporation status terminates automatically if the corporation fails to meet the requirements discussed above. For example, if the corporation inadvertently issues shares to more than 75 shareholders, or if a shareholder transfers his or her shares to a non-qualifying trust, the tax benefits of the S Corporation will be terminated as of the date of the disqualifying event.