Subchapter S Corporation Tax Status
When an individual in the United States wants to be taxed as a corporation, they must first meet the following requirements:
1. The amount of members in the entity cannot exceed 100 people
2. Members of the entity cannot be more than 20 percent shareholders of anyone else
3. A majority shareholding is not allowed by any one person or group of persons
4. There cannot be any unpaid-debt notes that are convertible at least into stock
5. The entity must hold meetings to elect a Board of Directors, and a Chairperson
6. The entity must have at least three shareholders (all meeting requirement number 1)
7. Records must be kept on all shareholders, officers, and stockholders
8. Shareholders cannot declare dividends or change members' capital shares without the approval of the IRS
9. The entity cannot be created to circumvent bankruptcy legal procedures
10. The entity cannot be used for passive investment purposes (such as buying real estate, et cetera)
11. At least 75% of the entity's income is from active trade or business activities (as opposed to passive investments)
12. The entity cannot have a net worth of more than $1,000,000
13. No dividends can be paid by the entity before corporate income tax is paid
14. Double taxation is not present
15. The entity cannot engage in illegal activities or Communist activities
16. The entity cannot reap any benefits from the death of a shareholder, such as life insurance money or bequests (as opposed to natural and adopted children)
17. The entity cannot be used to avoid taxes in another country; for example, if an American owns a British-based corporation which has an American operating subsidiary, then half of that corporation's profits generally may not be taxed by Great Britain (though some other countries do allow this).
The subchapter S corporation tax status is a special type of corporation that has limited liability and pass-through taxation. An S Corporation must meet the following conditions to be classified as an S Corporation:
Upon meeting these conditions, the corporation files a special IRS tax form to be recognized as an S Corporation. This form must be filed by the fifteenth day of the third month after the beginning of the corporation's tax year.
When a private company meets all of these requirements, it is known as an "S" corporation. On the fifteenth day of the third month after the beginning of the corporation's tax year, an S Corporation must file an IRS form 1120S with the IRS. This form, also called an 'accelerated' tax return, can be filed electronically through a company's online filing service.
An S Corporation may possess many different characteristics. For example, an S Corp may be set up to distribute its profits down to its individual shareholders – this is known as "flow-through taxation". The shareholders of an S Corp are not taxed on these profits unless they remit them to federal or state government.
The non-taxable income of an S corporation, as indicated above, is distributed to the shareholders as wages, salaries, or profits (an IRS term) at their discretion. S Corps could also be set up to distribute company profits in the form of dividends. These are taxed at the recipient's personal income tax rate. If a shareholder wishes not to accept either wages or dividends from the company he/she may elect to have the company pay them out in "qualified "reimbursement" expenses" (or a combination of wages and reimbursements), which are paid through a payroll service that withholds taxes for both employer and employee by setting up payroll deductions for these qualified plans.
An important aspect of S corporation taxation is the tax deduction. This allows an S Corp to reduce its gross income and pass on the total value of its deductions (such as employee wages, business expenses, etc.) to its shareholders as "deductions". This means that the company has a lower adjusted gross income, and can consequently file a smaller tax return.
S corporations are a type of entity known as a "pass-through entity", which means that the profits are passed through to all individual shareholders. Because pass-through entities are not taxed but rather their profits are allocated among their stakes in the company, they can be thought of as a form of more financial flexibility than corporations with separate ownership structures. This has led to the rise of many S corporations because they can be used to save on the paying of federal income taxes. This way, if an individual wants to avoid paying taxes, he/she may choose to form or join an S Corporation rather than a C Corporation.
When a company with S corporation status distributes its profits in the form of dividends, it is treated as a personal dividend and thus subject to personal income tax. However, when a company distributes its profits in the form of wages, it is treated as wage income and thus subject to payroll tax. As such, it enjoys a benefit since payroll taxes are lower than both personal income tax and corporate income tax rates.
The S corporation status is often preferred over a C corporation. An S corporation has limited liability, which means that the individual members or shareholders are not liable for the debts of the company. This makes it easier for employees and other stakeholders to work with an S Corporation, since they know that, if they suffer losses, their personal assets are safe from being seized. Furthermore, by forming an S Corporation, an individual may reduce his personal income tax burden by engaging in business activities through his S Corporation while still retaining a guaranteed income and medical benefits as a shareholder and benefiting from his dividends in retirement. However, this does not mean that all S corporations are automatically beneficial. If a company with S corporation status has no profits in a given year, none of the shareholders will be able to claim deductions on their personal income tax returns.
An S Corporation's earnings may be controlled by its shareholders, who can also allow employees to become shareholders if they wish. This makes it easier for the members of an S Corporation to manage their financial affairs since they are not required to pay corporate taxes as C Corporations are.
Conclusion
The main advantages of S Corporation status are that they alleviate the tax liability for the shareholder. The taxes paid by S corporations are reduced to a corporate tax rate. Furthermore, an S Corporation is set up so that its shareholders do not have personal liability on its financial obligation during business operations.
A disadvantage to this status is that there are other taxes involved with business activities under this type of structure, such as payroll taxes which are paid by employees, and in some cases even self-employment taxes. In addition, since shareholders do not receive personal income tax benefits from an S Corporation, it is harder to obtain investments and loans though this may be offset by higher liquidity for the economy when companies use debt financing under an S corporation structure.