Business Types Series-Part Two; The S Corporation

An S Corporation is initially formed in the same manner as a C Corporation, by filing incorporation documents with the state of incorporation. Once the business has incorporated, the owners may decide to file as an S Corporation, within approximately 75 days of incorporating. To do so, they need to file an IRS Form 2553. This does not create a separate type of corporation, but does change the corporation's tax structure.

The S Corporation has shareholders and is taxed like a sole proprietorship or a partnership rather than like a C Corporation, which is taxed as a separate business entity. Income is passed through to the shareholders, who report their pro rata income, or losses, on their individual tax returns. The corporation still files a federal tax return (Form 1120S) and possibly a state return as well, if required by individual state law. The S Corporation shows profits and losses as they pass through to the shareholders, and the corporation does not pay federal income tax as a separate entity. Some states, however, do tax S Corporations in the same manner as C Corporations. Check your state tax laws before electing S Corporation status.

Advantages of an S Corporation

Corporate losses can be passed through to the shareholders, and as the owner (and shareholder), you may be able to take the loss against income that appears on your personal return.

•                You can have the protection of limited personal liability without having to pay corporate taxes.

•                You can minimize self-employment tax and FICA tax. Your profits, as a shareholder, are not taxed in this manner.

•                It's easier to raise capital as a corporation than as a sole proprietorship or partnership.

Disadvantages of an S Corporation

•                Numerous regulations and requirements must be upheld by an S Corporation, including a limit on the number of shareholders (see list below).

•                Like a C Corporation, it can be costly to set up and follow corporate formalities.

•                Close scrutiny by the IRS of shareholder-employees, who must receive reasonable compensation (subject to employment taxes) before any nonwage distributions may be made to that shareholder-employee.

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Other regulations imposed on S Corporations

•                All shareholders must be U.S. citizens.

•                All shareholders must vote in favor of the S Corporation.

•                Benefits, such as health or accident insurance for employee shareholders (with at least a 2 percent partnership), may not be deducted by the corporation.

A corporation that plans to pass through dividends regularly to shareholders may want to elect S Corporation tax status. Also, a business owner who may want to take business losses on his or her own personal tax return, possibly to offset income earned by his or her spouse, may opt for this type of corporation. If you do set up an S Corporation and later decide that there's a better alternative for your business, you can vote to drop S Corporation status.

Like other corporations, the S Corporation can limit the personal liability of the owners. Creditors can go after the assets of the corporation and not the owners, if there are outstanding debts. It is important, however, that the owner keeps his or her personal financial records and those of the S Corporation completely separate, to avoid legal entanglements.

Next week we will discuss the "C" Corporation.