S corporations may be very beneficial to some companies as far as taxes are concerned. In general, an S corporation does not pay tax on its income. Instead, the income, losses, deductions and credits are passed through to its shareholders. They offer the best of both worlds to some companies as your clients receive the liability protection that comes with being incorporated and the business profits and losses pass through to the owner's personal tax returns. S corporations can be particularly favorable for start-up companies. If a business shows losses in some years, the owner may claim those losses in the current year of the loss on their personal tax return. For owners who plan to take all of the profits out of a company, an S corporation may make the most sense.
There are other benefits to choosing an S corporation as well. Interest your client incurs in order to purchase S corporation stock may be deductible as an investment interest expense. When it comes to selling your client's S corporation business, their taxable gain on the sale may be less than it would be if the business had been a C corporation. Keep in mind also that your client's decision to operate his/her business as an S corporation is not permanent. Should it become apparent that he/she would be better off operating as a C corporation regarding tax purposes, they can easily drop their S corporation status in the future.
The IRS allows most but not all small businesses to be S corporations. In order for your client's business to qualify for S corporation status, your business must meet all of the following requirements:
S corporations are subject to tax reporting rules similar to those of partnerships. However, shareholders are treated as employees for payroll tax purposes. Your client's company must give him/her a Schedule K-1, which lists their share of income or loss, deductions, and credits that must be reported on their tax return. Health insurance premiums paid by an S corporation for more than 2% stockholders are treated as wages and are therefore deductible on Form 1120-S by the corporation and reported to the stockholder on Form W-2.
It is important to note that there is a limitation on deductions as far as taxes go. Your client may only deduct losses to the extent of the money that they put into their company on their personal tax return. Furthermore, potential problems may arise when it comes to claiming losses from passive activities if your client does not actively work in their S corporation. They can only be used to offset passive income.
Following are what may be other unsavory or potentially problematic aspects of an S corporation: