An S Corporation is a corporate entity with 100 shareholders or less.
Originally adopted in 1958 S Corporations exist for the purpose of allowing businesses to select the legal form of a Corporation and by taxing the corporation’s income, passed through to the shareholders, (who may be in lower brackets than their corporations); and permitting the shareholders to net their corporate losses against income from other sources (S. Rep. No. 1983, 85th Cong., 2d Sess. 87 (1958), 1958-3 C.B. 922). Other benefits are avoidance of double taxation as a result of paying dividends to shareholders; and substantial reductions of IRS disputes over the reasonableness of compensation.
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the trade or business is organized. Now that the establishment of a corporation is so much easier, businesses that might traditionally have been partnerships or sole proprietorships are often formed as corporations with a small number of shareholders so that they can take advantage of the beneficial features of a Corporation.
S Corp Taxes
S corporations taxation resembles that of partnerships, without the Self Employment tax component. As with partnerships, the income, deductions, and tax credits flow through to shareholders annually, regardless of whether distributions are made. The income is taxed at the shareholder level, not at the corporate level, and the S Corporation’s net income is not taxed. Payments to S Corporation shareholders by the corporation are distributed tax free to the extent that the distributed earnings were previously taxed. Also there are certain corporate penalty taxes and the alternative minimum tax that do not apply to an S corporation. S Corporations are not eligible for a dividends received deduction. And unlike C corporations, S corporations are not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.
In order to make an election, filing a 2553 form with IRS, and be treated as an S corporation, it must be a domestic corporation, have only 100 shareholders or less, have only one class of stock. Note that spouses are automatically treated as a single shareholder. Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and tax exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.Profits and losses must be allocated to shareholders proportionately to each one’s interest in the business.
The S corporation also provides a form of insulation for small businesses to be more confident in moving forward with their new ideas or ventures. S corporation classification is a proven way for small businesses to achieve the benefits of corporate ownership. Some of those benefits is what we call the corporate veil. The ‘veil’ is the corporation from the shareholders, and protects the shareholders from being personally liable for the corporation’s debts, taxes and other obligations. However this protection is not ironclad or impenetrable. Where a court determines that a company’s business was not conducted in accordance with the provisions of corporate legislation, or that it is could be a shell for illegal activities, the court may hold the shareholders personally liable for the company’s obligations under the legal concept of lifting the corporate veil.