How will your S-Corporation be taxed? Who can be a shareholder? What are the tax benefits of an S-Corporation? When are the returns due?
To avoid two-tiered corporate taxation, you may want to consider electing S-Corporation status.
Many entrepreneurs have two goals when choosing a structure for their business: protecting their personal assets from business claims and having business profits taxed on their individual tax returns. Not long ago, an S-Corporation was the only choice for these business owners. In the last few years, however, the popularity of S-Corporations has plummeted as limited liability companies (LLCs) have largely replaced them. Still, S-Corporations are appropriate for some businesses. If you're interested, read on.
What Is an S-Corporation?
An S-Corporation is a regular corporation that has elected "S-Corporation" tax status. An S-Corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner.
In a regular corporation (also known as a C-Corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money that they draw from the corporation as salary, bonuses or dividends. By contrast, in an S-Corporation, all business profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships and LLCs). The S-Corporation itself does not pay any income tax, although a co-owned S-Corporation must file an informational tax return like a partnership or LLC -- to tell the IRS what each shareholder's portion of the corporate income is.
Most states follow the federal pattern when taxing S-Corporations: They don't impose a corporate tax, choosing instead to tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, do tax an S-Corporation like a regular corporation. The tax division of your state treasury department can tell you how S-Corporations are taxed in your state.
Should You Elect S-Corporation Status?
If your corporation meets certain criteria, such as having only shareholders who are U.S. citizens or residents, you can elect to do business as an S-Corporation. Operating as an S-Corporation rather than a regular corporation may be wise for several reasons:
- An S-Corporation generally allows you to pass business losses through to your personal income tax return, using it to offset any income that you (and your spouse, if you're married) have from other sources.
- When you sell your S-Corporation, your taxable gain on the sale of the business can be less than if you operated the business as a regular corporation.
But aside from the benefits, S-Corporations impose strict requirements. Here are the main rules:
- Each S-Corporation shareholder must be a U.S. citizen or resident.
- S-Corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
- An S-Corporation shareholder may not deduct corporate losses that exceed her "basis" in her stock -- which equals the amount of her investment in the company plus or minus a few adjustments.
- S-Corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.
Fortunately, your decision to elect to be an S-Corporation isn't permanent. If you later find there are tax advantages to being a regular corporation, you can drop your S-Corporation status after a certain amount of time.
How to Elect S-Corporation Status
To be treated as an S-Corporation, all shareholders must simply sign and file IRS Form 2553. Shareholders then pay income tax on their share of the corporation's income whether or not they actually receive the money. If the corporation suffers a loss, shareholders can claim their share of that loss.
S-Corporation Alternatives
You can accomplish the simultaneous goals of limited liability and pass-through taxation by creating a limited liability company (LLC). Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and because LLCs aren't subject to the many restrictions of S-Corporations, forming an LLC is often the better choice.
S Corporate State Tax Rates - Along with Federal Income Taxes it is very important to know the S-Corporation of the state you are conducting business.
Qualifying for S-Corporation Status: Generally, S-Corporations may have a maximum of 100 shareholders, and those shareholders must be individuals, although certain types of trusts and estates may qualify as a shareholder. Once your corporation makes the Subchapter S election to become an S-Corporation, profits and losses are passed through and reported on the individual shareholders' tax returns. This is the same basic "pass-through" treatment afforded partnerships and LLCs. The key distinction of the S-Corporation is that profits and losses are not taxed at the corporate/business level like they are if the business operates as a C-corporation.
IRS Filing: The S-Corporation must complete and file IRS Form 1120S to report its annual income to the IRS each year.
General Shareholder Requirements: ALL shareholders of the S-Corporation must be U.S. Citizens or have U.S. Residency Status. If for any reason S-Corporation shares are sold or transferred (even if by will, divorce, or other means) to a shareholder who is a foreign national, the corporation will lose its S-Corporation status and will be treated as a C-corporation. This also means that C-corporations, foreigners, or LLCs taxed as limited partnerships cannot be owners of an S-Corporation. This is important to know as it may affect your future investment options should your business require additional investors.
Only One Class of Stock: S-Corporations may issue only one class of stock. *A problem when you need investors.
Losing S-Corporation Status: An S-Corporation that loses its status may not re-elect S- Corporation status for a minimum of five years.
Who Should Elect S-Corporation Status: In general, if you want the limited liability of a corporation and the "pass-through" tax-treatment of a partnership, consider making the S-Corporation election. Later, we'll discuss other variables you should take into consideration before you make a final decision.
Adjust Basis: If a partnership makes an IRC §754 optional basis adjustment election, a purchaser of an interest of that partnership can "step up" the tax basis of his or her share of appreciated assets to reflect the purchase price. This privilege is NOT available to S-Corporations and their shareholders.
Tax Year-End: S-Corporations are generally required to use a calendar year-end for tax purposes (December 31st), whereas a C-Corporation may use a fiscal year-end instead.
S-Corporation Tax Return Due Dates
If you operate your business as an S-Corporation, the S-Corporation must file Form 1120S, U.S. Income Tax Return for an S-Corporation, on an annual basis, to report income and deductions. Each shareholder must receive a copy of Schedule K-1 (part of Form 1120S), Shareholder's Share of Income, Credits, Deductions, etc., or a substitute K-1. For S-Corporations with a calendar tax year, the due date for the annual return and the Schedule K-1 is March 15.
The S-Corporation may apply for an automatic six-month extension to file its annual return by filing Form 7004, Application for Automatic Extension of Time To File Corporation Income Tax Return, by March 15. The return would then be due on September 15. If your S-Corporation is filing for the six-month extension, it must deposit (at an authorized financial institution or a Federal Reserve Bank), what taxes it estimates it owes by the March 15 due date. An S-Corporation can use a Federal Tax Deposit (FTD) Coupon (IRS Form 8109) or it can deposit the amount due electronically. If an S-Corporation doesn't make a payment for the tax owed by the due date, it may be subject to interest and penalties on overdue taxes.
If your S-Corporation uses a fiscal year rather than a calendar year, the annual corporate return must be filed by the 15th day of the third month after the end of the S-Corporation's tax year. A fiscal year S-Corporation is entitled to the same automatic six-month extension to file its return to which a calendar year S-Corporation is entitled. The due date for the filing of the extension is the original due date of the return - the 15th day of the third month after the end of the S-Corporation's tax year. The actual return would then be due by the 15th day of the sixth month after the original return due date.
If you want your business to be treated as an S-Corporation, you must make an election by filing Form 2553, Election by a Small Business-Corporation. For S-Corporations using a calendar tax year, this election must be filed by March 15. For S-Corporations using a fiscal tax year, the election must be filed by the 15th day of the third month of the first tax year to which the choice will apply or at any time during the preceding tax year.
Notice: Concerning the above tax comments, keep the following in mind:
- This is how the above tax strategy works generally.
- This assumes that you are running a business with an honest "expectation of profit" and "that your expenses are ordinary, necessary, reasonable and directly related to your business."
- You document the deductions correctly.
Which State to Incorporate In?