S Corporation What Is It For Tax Purposes?
The S corporation is the business entity of choice for many small businesses. The S in S corporation is a tax designation, not a legal one. All corporations are created the same way under state law. A small business, however, must then chose to be treated as a C, S or non-profit for tax purposes. Important issues concerning S corporations are covered in this article.
C Corporation v. S Corporation
Federal tax laws automatically consider every corporation to be a C designation. A small business, however, may elect to be an S. Having each shareholder execute IRS form 2553, which is then filed with the IRS, accomplishes the election. The election must be made prior to the tax year in which it is going to be effective. If you want to be treated as an S corporation in 2006, you must file the election before December 31, 2005.
A C corporation stands alone for tax purposes. It must file tax returns and pay taxes on profits. Profits and losses are reported on the corporate tax return and do not pass through to shareholders. C corporations can elect any calendar month as the end of their fiscal year.
An S corporation is a pass through entity for tax purposes. It does not file a tax return for the purpose of paying taxes. All profits and losses are passed through to the shareholders. In turn, each shareholder reports the profit or loss on his or her individual tax returns in proportion to their ownership interest. If you own 60% of the total shares, 60% of the profits or losses must be reported on your personal tax returns. S corporations must have a fiscal year-end of December 31. If you intend to eventually take your business public, you cannot use an S corporation.
There are limitations on what type of corporate entities can make the S election. The biggest hurdles are:
- No more than 75 shareholders;
- Shareholders must be people, not other businesses, and
- Only one class of stock can be issued.
Write-Offs
There are negative aspects to electing an S designation. Unlike a C corporation, S corporations may not be able to deduct certain types of insurance and costs of doing business. The list is fairly complicated, so you should speak with a tax professional prior to deciding which designation works for your business.
S Corporation vs. LLCs
S corporations have a definite tax advantage over limited liability companies [LLC]. Distributions from LLCs are subject to self-employment taxes [15.2 percent]. However, distributions from S corporations can be broken down into salaries and dividends. The dividend distributions are not subject to the self-employment tax, which saves you 15.2% in taxes.
In Closing
The best tax entity for your business depends entirely on its nature. In many instances, S corporations are ideal.