Corporate View:

Advantages of a S Corporation

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 you 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 you incur in order to purchase S corporation stock may be deductible as an investment interest expense. When it comes to selling your S corporation business, your 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 decision to operate your business as an S corporation is not permanent. Should it become apparent that you would be better off operating as a C corporation regarding tax purposes, you can easily drop your S corporation status in the future.

The IRS allows most but not all small businesses to be S corporations. In order for your business to qualify for S corporation status, your business must meet all of the following requirements:

  • Be a US company
  • Have just one class of stock
  • Have no more than 75 shareholders who are all US citizens or residents and are not partnerships or other corporations

S corporations are subject to tax reporting rules similar to those of partnerships. However, shareholders are treated as employees for payroll tax purposes. Your company must give you a Schedule K-1, which lists your share of income or loss, deductions, and credits that must be reported on your 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. You may only deduct losses to the extent of the money that you put into your company on your personal tax return. Furthermore, potential problems may arise when it comes to claiming losses from passive activities if you do not actively work in your 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:

  • Most but not all states recognize the C corporation form of business
  • Tax preparation and filing can become very complex when an S corporation has out-of-state shareholders or does business in more than one state. Out-of-state shareholders are forced to file tax returns to both the state he lives in and the state the business resides in. If an S corporation does business in a few states, each shareholder may have to file tax returns to each of those states.
  • S corporations have to be concerned with shareholders taking too little in salary. The IRS may claim that the corporation purposely underpaid its shareholders in order to save in paying FICA taxes.
  • The fact that tax preference items are reported on shareholders' personal tax returns could cause an unexpected minimum tax problem for some.
  • The rules of accounting for an S corporation can get very complex, which in turn could cost more for accounting and tax preparation fees.