Business, Legal & Accounting Glossary
An S corporation is a corporation that for tax purposes chooses to pass all profits, losses, credits, and deductions on to its shareholders (i.e. pass-through entity). S corporation shareholders then report the profits, losses, credits, and deductions on their personal income taxes (i.e. by filing the Schedule K-1 sent to them by the S corporation) which are taxed at their individual rate. By passing on profits to shareholders, S corporations avoid double taxation while still providing shareholders with limited liability protection. Although the S corporation does not pay taxes on its corporate income, the S corporation is required to file Form 1120S with the IRS (i.e. U.S. Income Tax Return for an S Corporation) and prepare Schedule K-1 for its shareholders (i.e. Partner’s Share of Income, Deductions, Credits, etc.). Further, an S corporation still has to pay taxes on passive income and some built-in gains (i.e. BIG tax) when a C corporation elects to convert to an S corporation. An S corporation must be incorporated under United States laws, have no more than 100 shareholders, have only individuals, estates, and certain trusts as shareholders, and have only one class of stock to qualify as an S corporation. Additionally, insurance companies, financial institutions, and domestic international sales corporations are prohibited from becoming an S corporation. A corporation submits, and all shareholders sign, Form 2553 Election by a Small Business Corporation to become an S corporation. Such election is in effect until it is revoked or terminated.
A term that describes a profit-making corporation organized under state law whose shareholders have applied for and received subchapter S corporation status from the Internal Revenue Service. Electing to do business as an S corporation lets shareholders enjoy limited liability status, as would be true of any corporation, but be taxed like a partnership or sole proprietor. That is, instead of being taxed as a separate entity (as would be the case with a regular or C corporation) an S corporation is a pass-through tax entity: income taxes are reported and paid by the shareholders, not the S corporation. To qualify as an S corporation a number of IRS rules must be met, such as a limit of 75 shareholders and citizenship requirements.
An S corporation or S-corp, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
In general, an S Corporation does not pay any income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.
In order to make an election to be treated as an S corporation, the following requirements must be met:
If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: “Election by a Small Business Corporation” with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation’s shareholders. If a shareholder resides in a community property state, the shareholder’s spouse generally must also sign the 2553.
The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, often, the IRS will accept a late S election.
Some states such as New York require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.
If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation.
The S election affects the treatment of the corporation for Federal income tax purposes. The election does not change the requirements for that corporation for other Federal taxes such as FICA and Federal unemployment taxes.
As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders. Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may recategorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for the services they perform in their positions within the company.
Actual distributions of funds, as opposed to distributive shares, typically have no effect on shareholder tax liability. The term “pass-through” refers not to assets distributed by the corporation to the shareholder, but instead to the portion of the corporation’s income, losses, deductions or credits that are reported to the shareholder on Schedule K-1 and are shown by the shareholder on his or her own income tax return. However, a distribution to a shareholder that is in excess of the shareholder’s basis in his or her stock is taxed to the shareholder as a capital gain.
S corporations that have previously been C corporations may also, in certain circumstances, pay income taxes on untaxed profits that were generated when the corporation operated as a C corporation. This is very common with uncollected accounts receivable or appreciated real estate.
Example: If an S corporation that was formerly a C corporation sells an appreciated asset (such as real estate) and the appreciation occurred during the time the corporation was a C corporation, the S corporation will probably pay C corporation taxes on the appreciation–even though the corporation is an S corporation. This Built-In Gain (BIG) tax rate is 35% on the appreciated property, but is only realized if the BIG property is sold within 10 years.
While an S corporation is not taxed on its profits, the owners of an S corporation are taxed on their proportional shares of the S corporation’s profits.
Example: Widgets Inc, an S-Corp, makes $10,000,000 in net income (before payroll) in 2006 and is owned 51% by Bob and 49% by John. Keeping it simple, Bob and John both draw salaries of $94,200 (which is the Social Security Wage Base for 2006, after which no further Social Security tax is owed).
Employee salaries are subject to FICA tax (Social Security & Medicare tax) –currently 15.3 per cent–half of which is paid by the employer and half by the employee. The distribution of the additional profits from the S-Corp will be done without any further FICA tax liability.
Widgets Inc now has $9,797,187 of net income for 2006, after paying salaries ($10,000,000 – $94,200 * 1.0765 [employer FICA] * 2 employees). On Bob’s personal tax return, he will report $4,996,565 of business income (in addition to his $94,200 salary), and John will report $4,800,622. Also, remember that Bob and John each had the employee half of the FICA tax withheld from their salaries (94,200 * 0.0765 = 7,206.30 each.)
If for some reason, Bob (as the majority owner) were to decide not to distribute the money, both Bob and John would still owe taxes on their pro-rata allocation of business income, even though neither received any cash distribution. To avoid this “phantom income” scenario, S corporations commonly use shareholder agreements that stipulate at least enough distribution must be made for shareholders to pay the taxes on their distributive shares.
Quarterly estimated taxes must be paid by the individual to avoid tax penalties, even if this income is “phantom income”.
Bob and John will recognize significant tax savings compared to drawing the remainder of the business income as a salary subject to FICA taxation. While they have paid the maximum salary for which Social Security tax is assessed, there is no wage base for the continuation of the 1.45 per cent Medicare tax portion of FICA. By avoiding the employer and employee portions of FICA on this amount (2.9 per cent) they will together save a total of $284,118.
The difference would be even greater, percentage-wise, if Bob and John were paying themselves less than the Social Security Wage Base, as the Social Security portion of FICA is 12.4 per cent (total for the employer and employee halves).
In 2005, the IRS launched a study to assess the reporting compliance of S corporations. The study will examine 5,000 randomly selected S corporation returns from tax years 2003 and 2004, with audits expected to begin in late 2005. The IRS intends to use the results to measure compliance in the recording of income, deductions and credits from S corporations, and to formulate future audit criteria to better target likely non-compliant returns. This is part of a larger IRS effort to improve tax compliance and reduce the estimated $300 billion gap in gross reported figures each year. A large portion of that gap is thought to come from small businesses, and particularly S Corporations, which are now the most common corporate entity, numbering over 3 million in 2002, up from about 750,000 in 1985.
Form 1120S generally must be filed by March 15th of the year immediately following the calendar year covered by the return or, if a fiscal year (a year ending on the last day of a month other than December) is used, by the 15th day of the third month immediately following the last day of the fiscal year. The corporation must complete a Schedule K-1 for each person who was a shareholder at any time during the tax year and file it with the IRS along with Form 1120S. The second copy of the Schedule K-1 must be mailed to the shareholder.
Some but not all states recognize a state tax law equivalent to an S corporation, so that the S corporation in certain states may be treated the same way for state income tax purposes as it is treated for Federal purposes. A state taxing authority may require that a copy of the Form 1120S return be submitted to the state with the state income tax return.
S-corps pay a franchise tax of 1.5% of net income in the state of California (minimum $800). This should be taken into consideration when deciding on using a Limited liability company versus an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues (minimum $800), may be lower than the 1.5% net income tax. Conversely, on high gross revenue businesses, the LLC franchise tax fees may exceed the S corp net income tax.
In New York City, S-corporations are subject to the full corporate income tax at an 8.85% rate. However if the S-corporation can demonstrate that a portion of its business was done outside the city, that portion will not be subject to the additional tax.
S Corporations are a special kind of corporation identified in the Internal Revenue Code that are taxed differently from the more customary C corporations most people think of when they think of corporations.
S corporations differ from C corporations in one important particular: They are not taxed by the IRS as entities separate and distinct from their shareholders. In S corporations, the income and losses of the company pass directly to its shareholders. If the company earns $100,000 in profits during the year, its 50 percent shareholder would be responsible for showing 50 percent of the profit, or $50,000, on his personal tax return as income. If the company lost money during the year, each of its shareholders would be entitled to claim a portion of the company’s losses on his individual tax return as a loss.
These profits and losses pass directly to the shareholders without regard to whether or how much money the company distributes to them. If the company makes a profit and needs it to fund operations, the shareholders will have to show that profit on their individual tax returns and pay taxes on it even though they receive no cash. Agreements can be made among shareholders and management to require cash payments that are sufficient to pay taxes.
In the past, when maximum individual tax rates exceeded corporate maximum tax rates, S corporations were used primarily during the early stages of company development while losses exceeded profits. When individual tax rates fell below corporate tax rates under 1986 tax reform, S corporations came to be used in many cases to actually reduce federal taxes paid on corporate earnings by giving the company the benefits of its shareholders’ lower maximum tax rates. Appropriate use of the S form will always depend, in part, on the relative tax rates of corporations and individuals. These rates are always subject to change.
The S form can reduce the cost to the shareholders of their investments in a company that is losing money by allocating back to those shareholders the company’s losses in its first years. These losses can be used by the shareholders to reduce their income tax obligations and thereby effectively reduce their after-tax cost of investment. At the same time, however, the company loses the ability to use these losses to shelter future income from taxes and thereby increases the likelihood that it will need additional funding in the future.
S corporations are not particularly effective at attracting outside investors with the promise of allocating company losses to them to reduce their taxes. This is because losses and profits are allocated to S company shareholders on the basis of the number of shares held. In other words, an outside investor will only receive a portion of the company’s losses equal to his percentage ownership. If he puts in $1 million and gets 40 percent of the stock he will get only 40% of losses generated by the company’s use of his money. If the company loses all of his $1 million, he will only get $400,000 of it.
Other devices, such as limited partnerships and limited liability companies, permit more flexibility in the allocation of losses and profits and consequently are used more often than S corporations to attract investors who want to reduce the after-tax cost of their investments. Limited partnerships and limited liability companies can be structured so that almost all of the company’s losses are allocated to the outside investor. This means an investor who purchases a 40% interest in a limited entity could, nonetheless, receive almost all of the losses attributable to the use of his $1 million even though he may only be entitled to receive 40 percent of the profits.
Establishing an S corporation requires strict compliance with a number of IRS requirements, including rules relating to the nature of the company’s shareholders and its outstanding securities, and may not be available to all entrepreneurial companies. For example, S corporations are available only to companies organized under the laws of a state. Foreign corporations, even if they have assets or do business in the United States, cannot qualify. Even some domestic companies defined by the IRS as “ineligible corporations” (e.g., insurance companies, certain financial institutions, and other enumerated companies) cannot qualify. S corporations can have no more than 75 shareholders, all of whom must be individuals, estates, or certain qualifying trusts or tax exempt organizations. And only one class of stock can be issued without jeopardizing the S corporation’s tax status (although that class can be divided into subclasses with different voting rights). Certain consent and timing requirements must also be met to secure S corporation status.
As you might imagine, the flow-through of profits and losses is not without complications. For one thing, losses can be used by a shareholder only to the extent of his “basis” in his stock. Initially, this basis equals the individual’s purchase price for his stock plus his basis in any loans he makes to the company. As the company operates, this basis can fluctuate, however, generally increasing with company income and gains and decreasing with company losses. Also, losses generated to a shareholder may not be used to offset all types of income.
Because of the complexity of S corporations and the peculiarities of the manner in which they and their shareholders are taxed, entrepreneurs should always consult with their accountants and legal advisers before organizing S corporations. Failure to do so could result in unwanted surprises for the company and its shareholders.
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This glossary post was last updated: 11th August, 2022 | 0 Views.