Starting an S Corporation

A special hybrid type of entity, the S corporation elects to have a different tax treatment than its traditional C corporation cousins.

A special hybrid type of entity, the S corporation elects to have a different tax treatment than its traditional C corporation cousin. For most purposes, an S corporation is not a separate type of corporation. An S corporation operates in the same manner as a regular corporation. It must have directors, officers, and shareholders who function in the same manner as their regular corporation counterparts.

The difference between an S corporation and a regular corporation is that the S corporation has elected to be taxed similar to a partnership for federal tax purposes. After making the S election, the income, losses, tax credits, and other tax items of the corporation flow through the corporation to the shareholders. Thus, income is only taxed once, at the shareholder level. If a corporation does not make an S corporation election, corporate income is taxed twice; once at the corporate level, and again at the shareholder level when the corporate income is received by the shareholder as a dividend.

Forming an S Corporation

At first blush, it appears that every corporation should elect S corporation status to eliminate the double taxation of income. However, there are disadvantages to making the election and restrictions on who is eligible to make it.

Advantages of an S corporation.

• Cash method of accounting. Corporations must use the accrual method of accounting unless they are considered to be small corporations (a small corporation has gross receipts of $5,000,000 or less). S corporations, however, usually don't have to use the accrual method unless they have inventory.
• Personal holding company tax. An S corporation does not have earnings and profits, which would allow it to accumulate passive income that is then passed to its shareholders. A corporation that does not elect S corporation status and accumulates passive income is at risk of being classified as a personal holding company. For federal tax purposes, a personal holding company is a corporation that is owned by a small number of individuals and that receives most of its income in the form of dividends, interest, and rents. Undistributed personal holding company income is taxed at an additional 15 percent rate.

Disadvantages of an S corporation.

• Limit on number of shareholders. An S corporations may only have up to 100 shareholders.
• Limited losses. Although shareholders of S corporations have the ability to deduct pass-through losses, shareholders may not be able to deduct all the losses allocated to them because such losses are only available to the extent of the shareholder's basis in the S corporation. This is a tax accounting concept that basically limits the amount of losses that an S corporation shareholder can take. (However, C corporation shareholders ordinarily can't deduct any losses at all, unless their stock becomes worthless or is sold at a loss.)
• Calendar year. An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.
• One class of stock. An S corporation can only have one class of stock, which can impair the corporation's ability to raise capital. Non-voting stock is not considered a "separate class" for this purpose, however.
• Taxable fringe benefits. Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation.