What is an S Corporation?

Like a C corporation, the S corporation is established under state corporation laws. The major difference is that an S meets certain qualifications under Subchapter S of the Internal Revenue Code not to be taxed as a corporation for federal income tax purposes. The tax laws regarding S corporations are complex and the legal and accounting costs of starting and maintaining S status could override some of the tax advantages. In addition, state laws vary as to the taxability of an S corporation's income. Like C corporations, S corp. stockholders normally have limited liability for corporate obligations. S corporations are taxed, in most respects, like a partnership, rather than a corporation. There are usually no federal income taxes at the corporate level for S corporations. Profits or losses from S corporations flow directly through the company to the shareholders, thereby avoiding double taxation. Investors are also able to use losses from S corporations as direct tax deductions against other income, with limitations for those shareholders considered to be passive investors. Stockholders of S corporations are taxed on the net profits and gains of the corporation even if they do not receive any dividends from the corporation. In fact, since profits have already been taxed to the stockholders, dividends paid by S corporations normally are not taxable to the stockholders.

There are limits on the ownership structure of S corporations. First, only a small business corporation can elect S status. To qualify, the business must be a domestic corporation, have no more than 75 shareholders, and have only certain classes of eligible shareholders. For instance, C corporations, partnerships, LLCs, and trusts are not eligible shareholders of an S corp. All stockholders initially must consent to an S corporation election. However, once made, an S election can be revoked by shareholders with more than 50 of the stock. Once an election is revoked or terminated, an election cannot be made again for five years.

S corporations can have only one class of stock unless the only difference among the shares of multiple classes of common stock is in their voting rights. This means that an S can have both voting and nonvoting common stock. S corporations must continue to meet the foregoing conditions. Otherwise, the S election is terminated and the corporation is taxed as a C corporation henceforward.

Unlike C corporations, fringe benefits (including medical insurance and reimbursement plans disability income plans, and group term life insurance) paid to stockholders owning greater than two percent of company stock are nondeductible by the corporation. Health insurance premiums can be deducted by the owner-employee in the same way that self-employed individuals can deduct these expenses.