Like regular (“C”) corporations, S-corporations are legal entities separate
and distinct from their shareholders. S-corporations must adhere to guidelines
as set forth in Sub-chapter ‘S’ of the Internal Revenue Code. An S-corporation
is not a different entity that you file for when you first incorporate
your business. To designate your firm as an S-corp., you would first form
a regular (C-corp.) corporation, and then file the appropriate form with
the IRS to make it an S-corp. Unless an S-corp. election is made at the
time of incorporation, a business will be considered a “regular” (“C”)
corporation by default.
Total net earnings or losses in an S-corp. are prorated among its shareholders
on the basis of their percentage ownership in the company. These earnings
are “passed through” to the owners and incorporated into their individual
tax returns as regular income and then taxed at their respective tax rates.
S-corps. do not and cannot have a ‘retained earnings’ account, and all
earnings must be distributed to the owner(s). All income and losses credits
and deductions are washed through the S-corp. at the end of each fiscal
year; they go to the individual’s personal income tax return via Schedule
K-1 (Form 1120S).
S-corps. are therefore most beneficial for a mature company, or one
that is otherwise not dependent on retained earnings for ongoing business
investment. S-corps. may not be the right choice for smaller businesses
which are growing rapidly, because a smaller business will need the retained
earnings as a source of financing to grow and advance the business’ operations.
What often happens is that earnings are distributed to owners, who then
loan those funds back to the S-corp. in order to finance growth.
Advantages:
The chief advantage of an S-corp. is the same as it is for a regular
corporation: the liabilities of the owners are limited to their capital
investments. And like a regular corporation, an S-corp. helps owners protect
assets. However it differs from a C-corp. in its treatment of income taxes,
which often works out to the advantage of the owner(s). Wealthy shareholders
can offset personal taxable income with business/corporate losses. In an
S-corp., operational accounting is simpler, and accounting, legal and administrative
expenses are minimized relative to a C-corp.
Disadvantages
Because of the unique tax treatment, and the fact that business profits
and losses “pass-through” to owners’ personal tax forms, lenders are more
compelled to require personal guarantees from corporate officers as a condition
of supplying credit, thus negating the limited liability benefits afforded
by the S-corp. status.
Tax Implications
No double taxation. Sub Chapter-S earnings are not taxed as they
are in a regular corporation. Instead, earnings are channeled through
to the owners’ personal income tax forms and taxed at the owners’ individual
tax rates. This differs from a regular corporation, where earnings
can be taxed twice: once at the corporate level, and then at the owners’
personal tax rates when dividends are distributed. However, double taxation
can be avoided in a C-corp. simply by opting not to pay a dividend . Avoiding
the “double-taxation” scenario in an S-corp. results in more funds available
to owners:
C-Corp. S-Corp.
Pre-tax Income $1,000,000 $1,000,000
Corporate Taxes @ 34% $340,000
None
Corp. Net Income Distributed $660,000 $1,000,000
Individual Taxes @ 36% $216,000 $360,000
Net Funds Available $444,000 $640,000
Lower tax rates. The maximum tax rate for C-corporations is 34%. Individuals whose personal rates are lower than the C-corp. tax rate receive an immediate tax benefit.
Tax shelter. If S-corp. shareholders are in high tax brackets, which they often are, organizing as an S-corp. can help them offset personal taxable income with losses from S-corp. activities.
Asset Appreciation. If an S-corp. is dissolved with appreciated assets, taxes are due on asset appreciation, even if they have not been sold. For this reason, assets within an S-corp. are usually owned by outside entities and leased back to the company. So the S-corp. form is preferable when the value of fixed assets is large, or there is reason to believe that there will be significant appreciation.
Accumulated earnings. C-corporations are subjected to potential accumulated earnings tax if they amass more than $250,000 of retained earnings - $150,000 for personal service corporations.
Other tax issues. With S-corps., any capital gains generated from the sale of the company are simply incorporated into the former owners’ individual tax returns and taxed only once. With a C-corp., again, they are taxed at both the corporate and personal levels. Distributions to S-corp. owners are not subject to self-employment taxes when employee-stockholders are adequately compensated for their labor and management of business.
Rules and Regulations: Changes Effective Jan. 1, 1997.
- It has always been the rule that S-corps. can issue only one class
of stock.
- Prior to Dec. 31, 1996, S-corps. could have no more than 35 stockholders,
however that
maximum was recently raised to 75.
- Recent legislation dictates that certain tax exempt organizations
can now become shareholders
of S-corps. i.e., qualified pensions, profit sharing and
stock bonus plans.
- S-corps can now own 100% of the stock of a subsidiary C-corp. or
another S-corp.
- It used to be that once the S-corp. form was chosen, a business could
not switch back to a
C-corp. for five years. However, the five-year rule
was recently eliminated.
- The interest an individual incurs to buy S-corp. stock is potentially
deductible as an investment
interest expense.
WEB SITES.
http://ianrwww.unl.edu/ianb/pubs/nebfacts/nf255.htm
This site covers the requirements for maintaining S-corp. status, and
identifies those entities which are legally allowed to hold shares in an
S-corp. Detailed advantages and limitations of the S-corp. option are discussed,
as are those conditions which may impair the limited liability feature
of S-corporations.
http://www.dopkins.com/1092396.htm
Recent tax legislation has had a big impact on S-corporations.
This site outlines this impact and the new provisions, which went into
effect January 1, 1997.
http://www.businessform.com/scorp.html
This site covers those situations when S-corp. organization may not
be appropriate for certain businesses, particularly focusing on owner liabilities
and tax treatments.
http://www.ffgroup.com/contractor/taxes/scorp.html
This site covers the advantages and disadvantages of opting to organize
as an S-corp., focusing on the common misconceptions of S-corps, and the
particulars of the “passing-through” of corporate income.