S Corporations represent a unique hybrid in the American tax system, combining the liability protection of a traditional corporation with the tax advantages of a pass-through entity. Created under Subchapter S of the Internal Revenue Code in 1958, this business structure was designed to provide small businesses relief from the double taxation burden faced by C Corporations while maintaining the corporate veil of protection. The S Corporation’s distinctive tax treatment has made it an increasingly popular choice for small business owners seeking to optimize their tax position while protecting their personal assets.
S Corporation Status Eligibility Requirements
To qualify for S Corp status, businesses must meet specific IRS criteria:
- Be a domestic corporation
- Have only allowable shareholders (individuals, certain trusts, and estates)
- Maintain no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (such as certain financial institutions or insurance companies)
Pass-Through Taxation Benefits
Tax Structure: S Corporations avoid double taxation by passing business income, losses, deductions, and credits directly to shareholders. The corporation itself doesn’t pay federal income tax; instead, shareholders report their share of corporate income on individual tax returns.
Distribution Rules: Shareholders can receive both salary and dividends from the corporation. While salary is subject to employment taxes, qualified distributions are typically not subject to self-employment tax.
Shareholder Taxation
Reasonable Compensation: The IRS requires S Corporation owners who work in the business to pay themselves a “reasonable salary” based on market standards. This requirement helps prevent the avoidance of employment taxes through excessive dividend distributions.
Basis Calculations: Shareholders must carefully track their stock basis, which is adjusted annually for:
- Capital contributions
- Income items
- Distributions
- Losses and deductions
Filing Taxes as S Corps
S Corporations must file:
- Form 1120-S (annual corporate tax return)
- Schedule K-1 for each shareholder
- Form 2553 for initial S Corporation election
State Tax Considerations
While S Corporations receive favorable federal tax treatment, state taxation varies:
- Most states recognize S Corporation status
- Some states may impose entity-level taxes
- Certain states require separate S Corporation elections
Self-Employment Tax Savings: By properly structuring compensation between salary and distributions, shareholders can potentially reduce their self-employment tax liability.
Business Loss Deductions: Shareholders can deduct their share of business losses on personal tax returns, subject to basis limitations.
Potential Tax Pitfalls
Built-in Gains Tax: S Corporations that converted from C Corporations may face additional taxation on appreciated assets sold within five years of conversion.
Excess Passive Income: S Corporations with C Corporation earnings and profits must monitor passive income levels to avoid potential termination of S status.
Record-Keeping Requirements
Maintaining proper documentation is crucial for S Corporations:
- Corporate minutes and resolutions
- Stock transfer records
- Basis calculations
- Shareholder distribution records