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S-Corporation

Description

A Sub S election is available only to companies that have already incorporated. Corporations offer small business owners limited liability, which is attained when the small business incorporates. When the owners also make the “Subchapter S election,” the company is taxed like a partnership but retains the benefits of limited liability.

The Sub S structure allows investment by a maximum of 75 shareholders, but investors may be offered only regular common stock, thus limiting options such as preferred stock. Further, there are limits on the types of investors allowed to participate. For example, non-resident aliens may not invest. Insurance companies, banks, Domestic International Sales Corporations (DISCs), and certain other businesses are not allowed to seek Subchapter S status. The rules are complex, and a specialist may be needed to determine if they apply to your small business.

All income and losses are reported, but not paid, by the Sub S Corporation. The Sub S lists all owners and their share of the company. Each owner receives a copy of this list from the company via a K-1 statement. Owners then report all of the gains or losses on their Form 1040 (Individual Income Tax Return). Income deferral is not relevant here.

Sub S businesses must comply with most of the same regulatory requirements as corporations, such as filing articles of incorporation, calling and holding meetings of both directors and shareholders, and keeping accurate minutes of meetings. This results in higher set-up and operating costs than some other forms of business ownership.

Tax Treatment

Some small businesses choose the Sub S structure because it allows start-up losses to be passed to investors and deducted against personal income. After this, however, election of S Corporation status makes sense only if taxes at corporate rates are less than those at individual rates. Of course, this varies over time and depends upon income and state taxes. Once a small business elects to be treated as an S-Corp., switching back to a C-Corp. or other form of business ownership may be complex or impossible. Do not assume that it will be simple, easy, or cheap.

As with partnerships, Sub S Corporation income and losses are passed to shareholders and included on their individual tax returns. Corporations elect to be treated as Sub S companies by filing IRS Form 2553 (Election by a Small Business). As always with the IRS, however, there are exceptions (for example, if the LIFO inventory valuation method was used in the year prior to election as an S-Corp.), so it is important to check the regulations.

Normally, then, income is reported (but taxes are not paid) by the S-Corp. on IRS Form 1120S (Income Tax Return of an S Corporation). A Schedule K-1 is generated for each investor in proportion to gains (or losses). K-1’s are then provided to each shareholder, and the information ends up on Form 1040, Schedule E, of the Individual Income Tax Return for each shareholder.