An "S-Corporation" is a regular corporation that has between 1 and 100 shareholders and that passes-through net income or losses to shareholders. An S Corp is a corporation that elects to be treated as a pass-through entity (such as a sole proprietorship or partnership) for tax purposes. Since all corporate income is "passed through" directly to the shareholders who include the income on their individual tax returns, S Corporation are not subject to double taxation.
An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss.
One of the first things that those forming an S Corporation find most appealing is that those with S Corporation status are not required to pay both corporate and individual income taxes. However it is only fair to note that because the shareholders are not subject to double taxation, they may end up paying a higher personal income tax rate. When total taxes are considered over the course of the year, both on the corporate and on the individual level, those belonging to an S Corporation almost always end up paying fewer income taxes.
Employment tax rules are also favorable under an S Corporation versus a C Corporation. In Corporations such as the S Corporation where shareholder-employees are in smaller numbers, it is possible for all of the corporation's profits to be extracted in the form of a salary that is paid. This means that the corporation can pay out its profits in the form of wage increases or bonuses at the end of the year, making the taxable amount for income zero. When income is zero there is no need to pay income taxes. Employee-shareholder wages are subject to employee taxes but payments taken out of profit and distributed to shareholders are not subject to employment taxes.
Some businesses qualify for S-Corporation filing, while others do not. In order to start S-Corporation, the company may have only one class of stock. S Corporation formation is more suitable for small and family businesses and for those who starts their business with small investment.
S corporation set up may be fruitful for several reasons:
- Forming S corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you have from other sources.
- S Corp shareholders are not subject to self-employment taxes. These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.
- When you sell your S Corp, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.
There are many important differences between the corporation and LLC. The entities are taxed differently. An LLC is a pass-through tax entity. This means that the income to the entity is not taxed at the entity level; however, the entity does complete a tax return. The income or loss as shown on this return is "passed through" the business entity to the individual shareholders or interest holders, and is reported on their individual tax returns.
First of all, the tax system for an S-Corporation allows small businesses to operate based on a "pass-through" tax system similar to that of a Limited Liability Corporation (LLC).
When choosing S-Corporation status, the owners pass the profits or losses of the company to the shareholders, who in turn allocate those figures on their personal income tax returns. This method has obvious benefits to a corporation if the owners expect to experience an initial loss in the beginning months of their business.
Forming S-Corporation is not subject to corporate tax rates. Instead, an S-Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the S Corporation's profits are only taxed once - at the shareholder level. The IRS explains it this way: "On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss".
S-Corporations therefore avoid the so-called "double taxation" of dividends in most states.
The following restrictions are placed on S corporation formation:
- The S Corporation cannot have more than 100 shareholders;
- Each stockholder must be a U.S. citizen or resident, or an estate or qualifying trust of such person.
- Can only have one class of stock. Preferred stock is not allowed.
- Profits and losses must be accorded to owners in proportion with their ownership stake;
- Must use the calendar year as its fiscal year unless it can demonstrate to the IRS that another fiscal year satisfies a business purpose.
- Shareholders cannot deduct losses in excess of their investment and
- The corporation cannot deduct fringe benefits given to employees who own more than 2% of the corporation.
Yes S-Corporation registration, like regular C Corporation, is allowed to retain its net profits as operating capital. However, all profits are considered as-if they were distributed to shareholders. Thus an S-Corporation shareholder might be taxed on income they never received. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)
Passing income through to shareholders will sometimes prove to be a disadvantage. If the business is profitable from the very beginning, the shareholders then have to pay income tax on their share of that income, even when those profits are not distributed to them.
Reasonable salaries paid to employees are tax deductible for both S-Corporations and C-corporations.
Yes, fortunately, the decision to file S corporation status is not permanent. If the business becomes more profitable and there are tax advantages to being a regular corporation, S corporation registration status can be dropped after a certain amount of time.
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