Authored by Jayant Row in Business Management
Published on 04-10-2009
What is an S corporation? Under Subchapter S of Chapter 1 of the Internal Revenue Code of the United States, a corporation can elect to be taxed under this head. This ensures that the corporation does not pay any income tax, and is free to pass on its income or losses to the shareholders of the corporation. These shareholders then have to report this loss or income on their individual income tax returns and pay taxes accordingly.
S corporation status would allow the benefits of partnership taxation and also give the owners a limited liability protection from its creditors. S corporations are separate legal entities and therefore the shareholders are protected from any personal liability. All payments made by the S corporation to its shareholders are on a tax free basis. Other corporate penalty taxes and alternative minimum taxes are also not levied on a corporation which has elected to be listed as an S corporation. Other corporations have to pay a minimum tax even in case where their balance sheets do not show any profits.
An S corporation is not eligible to any dividends received reduction, and nor is it bound by the ten percent limit of taxable income that governs charitable contribution deductions in the case of other corporations. Owners of S corporations do not have to worry about double taxation as the corporation itself is tax free, and it the owners only pay taxes on their personal incomes from the corporation based on their own personal status.
Any interest paid for S corporation stocks is allowed as an expense. Money paid to the owners of an S corporation is not considered as wages and is therefore clear of the problem of paying any self-employment tax. S corporations are also allowed to charge 100% of fringe benefits like medical insurance as expenses.
To become an S corporation the owners have to make a separate election to do so, as by default a corporation is treated as a C corporation which has far less tax benefits and the possibility that the owners would be liable to double taxation. This can lead to substantial savings and allow the owners to have far greater funds at their disposal than would be in the case of a C corporation. A shareholder can further reduce his overall tax burden by transferring stock to children above the age of 13, who would be in a lower tax bracket and thus have an effective reduction in taxes. It also enables the corporation to pass on losses to the owners, who in turn could add this to their income from other sources and thus be eligible to pay lower taxes.
An S corporation has to be a small domestic business with not more than 35 shareholders. All these persons have to be natural citizens with no non residents allowed. There can be only one form of stock. It cannot be part of a larger group or a financial institution, foreign company or international sales corporation. All the shareholders must consent to the S corporation election.
An S corporation cannot choose its permitted tax year and must use a calendar year to file its tax returns. State taxes cannot be recovered as these taxes become the liability of the individual shareholders.