S Corporation Taxes

An S corporation is a creature of the federal tax laws. For all other purposes, it's treated as a regular corporation. So, to form an S corporation you first have to incorporate under state law.

Then, you must file a special IRS form electing to be taxed similarly to a partnership. This election preserves the corporation's limited liability under state law but avoids taxation at the corporate level. This means that income and losses of the S corporation are passed through to shareholders in much the same manner as a partnership passes through such items to partners.

Did You Know? According to the latest statistics from the IRS, S corporations continue to be the most popular corporate entity choice, representing 61.9 percent of all corporate entities. For the 2003 tax year, nearly 3.3 million S corporation returns were filed, up approximately 5.9 percent from the previous year. The number of shareholders in S corporations has also increased by 2.9 percent from the previous year to nearly 5.9 million.

One important difference between partnerships and S corporations is that in the S corporation all profits, losses, and other items that pass through must be allocated according to each shareholder's proportionate shares of stock; so, if you own 50 percent of the stock, you must receive 50 percent of the losses, profits, credits, etc. This is not the case with a partnership or an LLC, where one partner or member can receive different percentages (or changing percentages over time) of different tax items if the operating agreement so specifies.

S corporation requirements. Although the tax laws don't limit S corporation status to small corporations in terms of revenue, the requirements for electing can make it difficult to operate a large business as an S corporation. To obtain S corporation status under the federal income tax law, all of the following requirements must be met:

• The corporation must be a domestic corporation (a corporation organized under the laws of the United States, a state, or territory that is taxed as a corporation under local law).
• All shareholders must agree to the election.
• The corporation may not have more than one class of stock, however, voting and nonvoting shares are not considered to be two separate classes.
• The corporation may not have more than 100 shareholders.
• The corporation may not have any shareholder that is a nonresident alien or nonhuman entity (such as other corporations or partnerships), unless the shareholder is an estate or trust that is authorized to be an S corporation shareholder under the tax laws. Certain exempt organizations, such as qualified pension, profit-sharing, and stock bonus plans, or charitable organizations will be allowed to be shareholders in an S corporation (for purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder counts as one shareholder).
• Prior to 1997, an S corporations could not have subsidiaries, and could not be a member of an affiliated group of corporations. As of 1997, an S corporation can hold qualifying wholly owned subsidiaries and can own 80 percent or more of the stock of a C corporation. The C corporation subsidiary can elect to join in the filing of a consolidated return with its affiliated C corporations, but the S corporation cannot join in the election.