An S-Corporation (often referred to as a Subchapter S Corp.), is originally formed as a general corporation or close corporation but the Directors have elected with the IRS to be taxed under Subchapter S of the IRS Code. By filing IRS Form 2553 – Election by a Small Business Corporation, the Corporation is not treated as a distinct entity for tax purposes only. As a result, profits and losses flow-through to the individual shareholders as in a partnership or sole proprietorship. This form of taxation addresses one of the major disadvantages of a general corporation where the profits are taxed twice – once at the corporate level, and again at the individual shareholder level such as when a dividend is declared.
The S-Corporation is still quite popular with many domestic small businesses owners. It offers the best of both worlds, combining the tax advantages of a sole proprietorship or partnership with the limited liability and enduring life of a General Corporate structure. However, the S-Corporation election is not the ideal choice for some businesses due to a number of IRS restrictions and qualifications.
To elect S-Corporation status, your corporation must meet specific IRS guidelines:
> All shareholders must be citizens or permanent residents of the United States.
> Shareholders of an S-Corporation are limited to a maximum of 100.
> If an S Corporation is held by an "electing small business trust," then all beneficiaries of the trust must be individuals, estates or charitable organizations. Interests in the trust cannot be purchased.
> S Corporations may only issue one class of stock.
> Only 25 percent of the gross corporate income may be derived from passive income.
The IRS excludes certain types of General Corporation businesses from electing S-Corporation Status.
> Any financial institution that is a bank
> An insurance company which is taxed under Subchapter L
> A Domestic International Sales Corporation (DISC)
> Certain affiliated groups of corporations
Time Sensitive Election
Business owners need to plan in advance for S-Corporation status. The IRS requires that this election must be made shortly after forming your Corporation – within two months plus 15 days. Otherwise the corporation loses its ability to make the election until the following fiscal year.
Features of an S-Corporation
> Avoids double taxation with flow-through taxation to the shareholders
> Maintains the limited liability protection as a General Corporation
> IRS restrictions to no more than 100 shareholders
> Shareholders must be US citizens or permanent residents
> Shareholders and Directors must be individuals, not business entities
> Restrictions on the sale or transfer of stock