More S Corporation Information

S Corporation
The S corporation is a form of business structure thusly named because it is structured in such a way that it meets, and falls under the purview, of the IRS Revenue Code subchapter S. In many ways, it is very much like a traditional corporation, but with certain partnership-like traits that can benefit certain types of business organizations. One of the primary advantage of being treated as a subchapter S Corporation is that of pass-through taxation. Pass-through taxation exists when the shareholders are taxed at the individual level, like a partnership, rather than first at the company level, then again at the individual level. This gives the shareholders the best of both worlds in many instances--the pass-through taxation benefits of a simple partnership, and the limited liability and asset protection that a corporation affords.

Tax Advantages
A standard (or “C”) corporation is taxed on it’s earnings as a company, then any dividends distributed to individual shareholders are again taxed at the individual rate (about 15% for Federal taxes). This is known as the double-taxation jeopardy and is one of the main reasons for the existence of the S Corporation.

The S Corporation, on the other hand, is not taxed at the company level. Instead, it is taxed based on the distributions to the shareholders at the individual shareholders’ marginal rate. One thing to bear in mind is that this taxation occurs whether or not there is an actual distribution to the shareholders. This means that the income is only taxed once, as a distribution to the share holders.

This pass-through taxation method can be both a boon and a nuisance. For example, let’s take an imaginary company named Wallaby, Inc. We’ll say there are three partners, John, Jack, and Jacob, with John owning 50%, Jack owning 25%, and Jacob the remaining 25%. Wallaby, Inc. earned $10 million last year as net income. At tax time, John will have to claim $5 million, Jack $2.5 million, and Jacob the remaining $2.5 million. If John, as the majority owner, decides not to distribute the net income profit, John, Jack and Jacob will still be liable for taxes on the earnings as if a distribution was made in that manner, even though none of the three received an actual cash distribution. This situation can be manipulated via what is termed a “squeeze play” by a majority partner (or partners in collusion) in an attempt to squeeze out a minority or undesirable partner.

In the traditional corporation, although there is the initial corporate tax, there is no dividend tax at the individual shareholder level unless an actual distribution is made.

Another limitation to the S Corporation is the fact that the number of shareholders is limited to 100, and if there is only one shareholder, there is the ever-present danger that the IRS disregards the subchapter S status and treats the company as a standard corporation for tax purposes. This is more likely the case when there is any sort of deviation from the corporate formalities.

S Corporation Formalities
The forming of an organization as an S corporation also means that, just like with a traditional corporation, the corporate formalities must be observed. Corporate formalities are the actions that must be performed by a corporation’s director, officers, or shareholders in order to maintain the protection afforded by the formation of the corporation. These are essential procedures that serve to protect the personal assets of a Corporation’s directors, officers, and shareholders.

The Formalities can be summarized as follows:

Corporate Funds must be maintained separate and apart from Personal Funds.
There must be Annual Meetings of the Board of Directors.
There must exist Corporate Minutes and an officer assigned to take and care for the minutes.
All Corporate engagements, contracts, and strategic acquisitions must be in Written Form.

Much more in-depth discussion and descriptions of the corporate formalities can be found in our section on Corporation Operating Formalities, but it bears mentioning that the adherence to the corporate formalities is a must for the successful operation of any corporation. These formalities serve to preserve the limited liability and tax benefits afforded by the corporate status.

Filing for Subchapter S Treatment
The steps necessary to achieve S corporation status are not terribly complicated, but need strict attention paid to them to ensure that the status withstands scrutiny and the benefits of the status are enjoyed.

To start, the shareholder(s) of an existing corporation, or the owner of a new corporation, must execute IRS Form 2553, along with any local documentation if the state of residence for the corporation recognizes S corporations (some states treat all corporations the same, and yet others allow for the S designation and follow similar taxation strategies). The execution and filing of this election must occur before the 16th day of the third month following the close of the corporation tax year in order for the corporation to be considered for S status during the current tax year. The corporation must meet the S Corporation qualifications during the aforementioned 2.5 months, and all shareholders must agree to the status, irrespective of whether or not they own stock at the time of the change in status.

Relinquishing S Election Status
S Corporation status can be relinquished voluntarily via the filing of the appropriate statement of termination. This type of revocation of status may only be made with the approval and consent of the majority shareholders. The complete process, and all necessary supporting information requirements, can be found in the IRS Regulations section 1.1362-6(a)(3) and in Instructions for IRS Form 1120S, U.S. Income Tax Return for an S Corporation.

Involuntary revocation or termination of status can occur any time the Regulatory agencies, such as the IRS or the State Franchise Tax Board, proclaim a violation of the eligibility requirements, or to much greater detriment, any failure to observe the corporate formalities that brings to question the separate legal entity status of the corporation.

Who Should Organize as an S Corporation?
Partnerships, groups of investors, or even existing corporate shareholders looking for the dual benefits of enjoying limited liability and pass-through taxation should seriously consider the S Corporation status, provided that the rules for eligibility can be met and sustained. There are many benefits to be garnered from this form of organization, though this is a decision that should be made with the assistance of an informed expert in subchapter S Corporations.