People often ask me what is an S corporation, what are the requirements to be an S corporation or whether a certain action will revoke an S election? So let’s discuss S corporations today.
What is an S Corporation?
An S corporation is a hybrid between a C corporation and a partnership. It will avoid the double taxation disadvantage associated with a C corporation. All the income, losses, deductions and credits pass through to the shareholders and everything is taxed once at the Federal level. Some states also tax S corporation income. For instance, California imposes a 1.5% tax on S corporation income.
A Tax Example
Let me give you an example. XYZ corporation has a taxable income of 100,000. Under C corporation tax treatment, the $100,000 will be taxed once at the corporate level at 34% and a second time when it distributes the income to the shareholders as a dividend. As for an S corporation, the $100,000 is only taxed once when it passes through to the shareholder. It will be taxed at the S shareholder’s individual tax bracket.
To qualify as an S corporation, you must file an election Form 2553 with the Internal Revenue Service within 75 days of your corporation formation or 75 days after the beginning of the tax year. In our experience, we have seen that filing a late S election after the 75 days have passed is usually acceptable and the S election will usually be granted. No promises though.
The IRS will notify the corporation if their election has been accepted. You might also need to apply for an S election in your particular state. Each state’s regulation is different so be sure to contact your tax advisor.
The 8 Requirements
There are 8 requirements the taxpayer has to meet to be an S corporation.
It is a domestic corporation or entity.
It has no more than 100 shareholders. An individual and his or her spouse can be considered as one shareholder.
Shareholders must be an individual, estate, trust, tax exempt organization or other S corporation. A C corporation or partnership cannot be the shareholder of an S Corporation.
It has no nonresident alien shareholders.
It has only one class of stock, all with identical rights to distribution and liquidation proceeds.
It is not one of the ineligible corporations such as a financial institution, insurance company, or domestic international sales corporation (DISC), etc.
It has or will adopt a December 31 tax year, a natural business year, an ownership tax year or a 52-53 week tax year.
It has each shareholder’s consent. If an individual and his or her spouse have a community interest in the corporation, both must sign the consent statement.
The corporation should continue to meet the above requirements after the S election is accepted. For instance, the corporation should not admit more than 100 shareholders or foreign shareholders after the election is made. Failure to maintain the S status will cause the S election to be revoked. If the S election is revoked, the entity will be taxed as a C corporation and subject to double taxation.
So keep the above in mind when forming your next corporation and be sure to contact us if you have any questions.
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Hazel Ho, CPA, is a tax manager at Milam, Knecht & Warner, LLP. Her professional background includes experience at the international CPA firm of Ernst & Young LLP. Outside of work, Hazel enjoys spending her time practicing yoga, zumba, snowboarding, and laughing with her little girl.