Basics of an S Corporation

Posted: May 7, 2009 1:41 PM
Updated: May 7, 2009 1:41 PM

Real Small Business: Building Your Business

From the Editors of Real Small Business

S Corporation status gives you the liability protection of a corporation, and allows you to pay taxes on the same basis as a sole proprietor or partnership, that means you pay tax at the personal rate and your profits are your salary. S Corporations limit the number of corporate shareholders to 75, stipulate that all shareholders be U.S. citizens, and require that shareholders be individuals rather than other corporations or estates. The only exceptions are tax-exempt, charitable organizations.
Many tax and legal experts recommend S Corporation status for smaller entities and start-ups. It can provide you with corporate liability protection, and potentially reduce your tax burden. In addition, if your business experiences a loss in its first year, you can generally pass that loss through to your personal income tax return. There are other potential tax advantages as well, including the ability to deduct (as an investment interest expense) interest you incur to buy S Corporation stock. However, tax laws vary from state to state. The tax division of your state treasury department can tell you how S corporations are taxed in your state. It's also a good idea to speak with your accountant or tax advisor.
On the downside, S Corporations are limited in terms of the number of deductions for fringe benefits such as heath insurance, group term life insurance, deferred compensation plans, and others. While a C Corporation can deduct these benefits for all owner-employees, an S Corporation cannot deduct them for an owner-employee who owns 2% or more of the corporate stock.
To become an S Corporation, all shareholders must file and sign IRS Form 2553. Shareholders pay income tax on their share of the corporation's income, regardless of whether they actually received the money or not. If the corporation suffered a loss, shareholders can claim their share of that loss.
Most states follow the federal pattern of not imposing corporate tax on an S Corporation, but instead taxing the shareholders. Be aware, however, that some states tax an S Corporation the same as a C Corporation. You might want to contact the tax division of your state treasury department to find out how this is handled in your state.
Advantages
Corporate liability protection for shareholders
Profits are taxed at the personal rate
Potential to write off losses against personal income tax
Disadvantages
Requires more paperwork and is more expensive than partnership or sole proprietorship
No benefit deduction for owner-employees with 2% or more of corporate stock