S Corporation 

An S corporation or S-corp, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

Unlike a regular C corporation, an S corporation generally pays no corporate income taxes on its profits. Instead, the shareholders in the S corporation pay income taxes on their proportionate shares, called distributive shares, of the S corporation's profits. Shareholders must report the income (and pay a related tax, if any) regardless of whether the shareholders receive distributions from the S corporation.

Qualification

In order to make an election to be treated as an S corporation, the following requirements must be met:

1. Must be an eligible entity (a domestic corporation, a partnership or a single-member or multiple member limited liability company).
2. Must not have more than 100 shareholders.
3. Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
4. Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are to be excluded. However, certain tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
5. Must have only one class of stock.
6. Profits and losses must be allocated to shareholders proportionately to each one's interest in the business.

If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file Form 2553: "Election by a Small Business Corporation" with the Internal Revenue Service (IRS). The Form 2553 must be signed by all of the corporation's shareholders. If a shareholder resides in a community property state, the shareholder's spouse generally must also sign the 2553.

The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, oftentimes, the IRS will accept a late S election.

Some states such as New York require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.

If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation.

Taxation of S Corporation Distributive Share

While an S corporation is not taxed on its profits, the owners of an S corporation are taxed on their proportional shares of the S corporation's profits.

Example: Widgets Inc, an S-Corp, makes $10,000,000 in net income (before payroll) in 2006 and is owned 51% by Bob and 49% by John. Keeping it simple, Bob and John both draw salaries of $94,200 (which is the Social Security Wage Base for 2006, after which no further Social Security tax is owed).

Employee salaries are subject to FICA tax (Social Security & Medicare tax)--currently 15.3 percent--half of which is paid by both the employer and employee. The distribution of the additional profits from the S-Corp will be done without any further FICA tax liability.

Widgets Inc now has $9,797,187 of net income for 2006, after paying salaries ($10,000,000 - $94,200 * 0.0765 [employer FICA] * 2 employees). On Bob's personal tax return, he will report $4,996,565 of business income (in addition to his $94,200 salary), and John will report $4,800,622. Also, remember that Bob and John each had the employee half of the FICA tax withheld from their salaries (94,200 * 0.0765 = 7,206.30 each.)

If for some reason, Bob (as the majority owner) were to decide not to distribute the money, both Bob and John would still owe taxes on their pro-rata allocation of business income, even though neither received any cash distribution. To avoid this "phantom income" scenario, S corporations commonly use shareholder agreements that stipulate at least enough distribution must be made for shareholders to pay the taxes on their distributive shares.

Quarterly estimated taxes must be paid by the individual to avoid tax penalties. Even if "phantom income".

Bob and John will recognize significant tax savings compared to drawing the remainder of the business income as a salary subject to FICA taxation. While they have paid the maximum salary for which Social Security tax is assessed, there is no wage base for the 1.45 percent Medicare tax portion of FICA. By avoiding the employer and employee portions of FICA on this amount (2.9 percent) they will together save a total of $284,118.

The difference would be even greater, percentage-wise, if Bob and John were paying themselves less than the Social Security Wage Base, as the Social Security portion of FICA is 12.4 percent (total for the employer and employee halves).

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