A Practical Guide to S Corporations
The "S corporation" is simply a corporation that has opted to be taxed under Subchapter S of the Internal Revenue Code instead of Subchapter C, as other corporations are. Obtaining S corporation status can offer tax advantages to a corporation, depending on a number of factors. To become an S corporation, a corporation must meet certain requirements imposed by the Internal Revenue Code.
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Requirements
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To qualify as an S corporation, a corporation must have no more than 100 shareholders. It is disqualified if it offers more than one class of shares, such as ordinary and preferred shares. It is also disqualified if any of its shareholders are nonresident aliens, partners or corporations. It must be organized under the laws of a U.S. jurisdiction. Neither insurance companies nor some types of financial institutions are eligible for S corporation status. An eligible corporation may choose to be taxed under Subchapter C but may also choose to be taxed under Subchapter S by filing Form 2553 with the IRS. Qualifying LLCs may also file Form 2553.
Flow-Through Taxation
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S corporations enjoy "flow-through" federal income taxation. C corporation profits are taxed twice -- once at corporate tax rates when the corporation receives it, and again at individual income tax rates when shareholders receive it in the form of dividends. S corporation profit, by contrast, "flows through" the corporation and is taxed once at the individual shareholder level.
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Retained Earnings
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Although S corporation profits are taxed only once, the IRS attributes all of its income to shareholders every year. This means that if you own 20 percent of the shares in an S corporation, you will be taxed on 20 percent of its profits, even if it distributes no dividends to shareholders. If the corporation is highly profitable but does not distribute much of its income, S corporation status may not be in your best interest.
Shareholder Salaries
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Salaries paid to employees are subject to Social Security and Medicare tax, while corporate profits are not. Since many S corporations are small businesses with shareholders doubling as employees, some S corporations have attempted to lower their tax burden by paying shareholder-employees low salaries but distributing generous dividends to them. The IRS, aware of this phenomenon, insists that S corporations pay their shareholder-employees reasonably high salaries. Failure to do so may trigger an IRS audit.
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References
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