S-Corporations are corporations that choose an “S-Corporation” status for tax purposes. Under certain circumstances, shareholders of a corporation may make an election under Subchapter S of Chapter 1 of the Internal Revenue Code (Election by a Small Business Corporation, Form 2553) opting for pass through taxation. With pass through taxation, shareholders are taxed once on the income they earn the same way partners in a partnership or members of limited liability companies are taxed. Forming a business entity with S-Corporation status allows a business owner to take advantage of the limited liability that corporate shareholders have in a C-Corporation, while avoiding double taxation. So long as the corporation qualifies for Subchapter S treatment, taxation will be passed on directly to the owners as individuals. The corporation itself is not subject to the corporate tax rate on its profits. S-Corporation shareholders report income and losses on their personal income tax returns so that they are taxed based on their individual tax rates.
Qualifying for S-Corporation Status
To qualify for a Subchapter S treatment, the corporation must: be a domestic corporation; have only one class of stock; distribute profits and losses proportionate to each shareholder’s ownership interest; and be limited to no more than 100 shareholders who are natural persons and United States citizens. Spouses are automatically treated as a single shareholder and certain lineal family members may elect to be treated as a single shareholder. 501(c)(3) non-profit corporations and certain other tax-exempt corporations, trusts and estates may also be shareholders in an S-Corporation. In addition to these qualifications, there are limitations on tax deductible fringe benefits an S-Corporation can offer.
Forming an S-Corporation
As with the formation of a C-Corporation, organizers of an S-Corporation must file articles of incorporation with the California Secretary of State. In addition, the organizers should prepare By-Laws, enter into a Shareholders' Agreement (unless there is only one shareholder) and conduct an organizational meeting of both the shareholders and the board of directors followed by the preparation of Minutes for both meetings. In most cases, it is best to incorporate in the state where the bulk of a company's business will be conducted. Prior to forming an S-Corporation, its organizers should first verify that the corporation meets all of the eligibility requirements for forming an S-Corporation. To receive S-Corporation status, all shareholders must sign and file IRS form 2553, Election by a Small Business Corporation in a timely manner.
For many companies, any disadvantages of electing S-Corporation status, such as restrictions on stock ownership and stricter IRS scrutiny, are far outweighed by the pass through taxation available to S-Corporations. S-Corporations also protect shareholders’ personal assets so that they will not be liable for the debts and liabilities of the business. In addition, it is always a good idea for those considering an S-Corporation to compare the advantages and disadvantages with those of a Limited Liability Company (LLC) before the formation of the entity.
For a free consultation, please contact San Diego Corporate Lawyer Donald R. Oder at (888) 900-9002.