A small business may operate under various legal forms. The most common of these, particularly for new startups, is the sole proprietorship. The individual who owns the business receives all of its income and is responsible for all of the business's debts—including other liabilities to which the business may be subject (e.g. a customer slipping on that banana peel in the store). Under a sole proprietorship, the individual and the business are the same thing. If the business fails, the owner may have to sell his or her house and other goods to satisfy its debts. The principal advantage of incorporation is that the owner as a person is separated from the corporation, the latter viewed as an artificial "person." They are now two, not one. The corporation carries its own liabilities. When the corporation fails, the liability of its owners is limited to whatever they have invested—and no more. The business owner who started a business with $10,000 may lose the $10,000—but not the $300,000 he or she owns in other assets. The downside of incorporation is that the income of the corporation is taxed separately—and the owner gets his or her share only after the corporate tax has been deducted. The owner also then owes additional taxes on his or her earnings. Thus double taxation is involved. As a sole proprietor, the owner is taxed once but is personally exposed to all of the liabilities of the business. As a corporate entity, the owner is shielded from liabilities but is taxed twice. Is there a way to have the best of both worlds? Yes, there is. It is called the S Corporation.
The S corporation derives its name from Subchapter S of the Internal Revenue Code which provides corporations a "tax election" option—a choice on how they want to be taxed. Under Subchapter S, a company may elect to pass all of its profits to its shareholders directly. The shareholders are then responsible for paying taxes on this income stream. The corporation itself is not taxed. Meanwhile the limited liability benefits of the regular corporate form continue. Not all corporations, however, qualify for the Subchapter S tax election. The company may only have a maximum of 75 investors. They must all agree to this choice. All must be residents in the U.S. or U.S. citizens. The IRS also excludes certain types of companies described below. A regular corporation, called a C corporation, can convert itself to S status—and thus have it both ways.
BECOMING AN S CORPORATION
Filing with the Internal Revenue Service
Once a business has incorporated in the usual way and has filed its articles of incorporation, it can elect S corporation status by filing Form 2553 with the IRS. All of the corporation's shareholders must sign this form or file special shareholder consent forms. The rules apply to anyone who has held stock in the company during the current tax year. To be eligible for S corporation status for the current tax year, a corporation must file the form by the fifteenth day of the third month of the corporation's tax year. Once the form has been filed, it is not necessary to file every year.
For a corporation to be eligible for S corporation status, the following conditions must be met and maintained:
- The business must have become a corporation prior to filing for S corporation status. See the entry Incorporation for more information on this process.
- The business must also have no more than 75 stockholders. Until the Small Business Job Protection Act of 1996 was passed, corporations with more than 35 shareholders were disqualified.
- All of the business's stock must be owned by individuals who reside in or are citizens of the United States. Estates or trusts may be allowed as stockholders, but corporate or foreign investors are not allowed. This includes other businesses that are not corporations, such as partnerships or sole proprietorships. This provision, therefore, excludes corporate subsidiaries from claiming S corporation status.
- The business must issue only one class of stock. This means that with the purchase of stock must come the same economic rights, such as receiving dividends or compensation in the event of liquidation at the same time and in the same amount per share as all other shareholders. Voting rights may differ amongst the shareholders without being considered a sign of the possession of different classes of stock.
Those businesses that are ineligible for S corporation status include:
- All financial institutions, such as banks and savings and loans.
- Insurance companies.
- Businesses that receive 95 percent or more of their gross income from exports (also known as DISCs, Domestic International Sales Corporations).
- Corporations that use the possessions tax credit (a type of foreign tax credit).
- C Corporations that have been S corporations within the last five years.
The chief advantage of the S corporation is its treatment under the tax law, particularly if the company routinely pays high dividends. Under the C form, stockholders actually "feel" the double taxation of corporate profits only when they get dividends: under an S form, they would get more money. S corporation stockholders also get assigned losses if the company sustains them. These losses do not require stockholders to pay any money to the company but allow them to factor the reported losses into their own income taxes and thus reduce their taxes on other income.
Paying Taxes on "Absent" Income
Most healthy corporations reinvest all or substantial portions of their profits into operations to fund growth. Dividends paid are therefore just a portion of all profits. In C corporations, stockholders only pay taxes on dividends, year to year, and are not liable for taxes on the total profit made. But when the S corporation retains its profits for growth, stockholders must pay taxes on that profit even though they do not get a check in the mail—and the higher the profits, the more rapid the growth, the higher the taxes. This structural arrangement can thus produce tensions between stockholder and the corporation—stockholders either required to keep "investing" in a going concern indirectly by paying its taxes or, conversely, pressuring the corporation to distribute more of its profits and thus potentially slowing the company's growth.
Taxed Fringe Benefits
Unlike C corporations—but like partnerships—S corporations may not deduct fringe benefits, given to shareholders who are also employees, as a business expense. As a result, shareholder-employees must pay taxes on those benefits. These rules apply to all shareholders who own more than two percent of the corporation's stock and are employees of the corporation. But all employees who are not stockholders may receive benefits without paying taxes.
Pay Vs. Profit Sharing
S corporations must be careful to pay stockholders who work for the corporation salaries "deemed reasonable" by industry standards. The temptation exists to pay stockholders low salaries and to compensate them, instead, from profits—thus avoiding payroll taxes. But if the stockholder-employee is not paid at a reasonable rate, the IRS may require the stockholder to pay payroll taxes on the totality of the income received from the S corporation—which may be substantial.
State and Local Taxes
S corporations are sanctioned under federal tax laws which may not be matched by local and state governments. Thus S corporations may still have to pay taxes as corporations to states and localities.
S corporations must act like S corporations and maintain careful records. This is not, per se, a disadvantage of the form: after all, all businesses should keep good records. But some business owners see the S corporation as merely one way to escape liabilities by gaining the benefits of limited liability while continuing to operate as sole proprietorships. Under prevailing law, a corporation (S or C) must adhere to regular forms: it must separate personal from corporate accounts, hold regular directors' and shareholders' meetings, take minutes, and also use the appropriate corporate designation on its documents and stationary. Failing to adhere to these requirements, the S corporation may not prevail in court in the case of a liability action, with the result that the stockholders are severally and individually held to be liable.
TERMINATING S CORPORATION STATUS
An S corporation may voluntarily revoke its status if it finds that S status is no longer beneficial; it may also lose the status involuntarily. In the first case, a majority of the stockholders is required to make the decision, and a simple notice to the IRS is all that is required. In the second case, any act which disqualifies the corporation's eligibility for S status will result in the termination of that status effective on the date that the infraction occurs. An example of such a disqualification would be acquiring a single foreign stockholder living abroad. In either case, the corporation becomes a C corporation in the absence of S corporation status.
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Fishman, Stephen. Working for Yourself: Law and Taxes for Independent Contractors, Freelancers and Consultants. Nolo, 2004.
Mancuso, Anthony. LLC Or Corporation? Nolo, 2005.
Nathan, Karen, and Alice Magos. Incorporate! McGraw-Hill, 2003.
U.S. Small Business Administration. "Forms of Business Ownership." Available from http://www.sba.gov/starting_business/legal/forms.html. Retrieved on 5 June 2006.