S Corporation Defined

An S corporation although essentially the same as a C corporation but has a special tax status with the Internal Revenue Service. The special tax status allows the S corporation to pass through the profit or loss to it's shareholders. Although majority of the states recognize the S status, certain states do not. To obtain the S status the corporation must file Form 2553 with the Internal Revenue Service.

Commonly used by small business proprietors, the S Corp pays no corporate taxes, but instead passes profits and losses directly to its owners - the shareholders who declare such profits and losses as part of their personal taxable income.

When a business is incorporated, it is automatically incorporated as a regular corporation - C Corporation unless an S Corporation election is made. There are certain eligibility requirements which much be met in order to elect treatment as an S Corporation. The corporation must be a domestic, small business corporation with no more than 35 share holders (75 for tax years beginning in 1997). Only natural persons, qualified trusts and estates can be the shareholders. S Corporations cannot be owned by other corporations. There cannot be any non resident alien shareholder. There can only be one class of shares. Financial institution, foreign corporations, insurance companies and domestic international sales corporations (DISC) or former DISC are not eligible for S Corporation election. All shareholders must consent to the election to be treated as an S Corporation. The Form 2533 must be completed and filed with the Internal Revenue Service within 2 1/2 months after the beginning of the year in which the election is to be effective. Once an S Corporation election is made, it applies for all succeeding years unless the election is terminated. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation's ceasing to satisfy the eligibility requirements for S Corporation status, or by the corporation's failing a passive investment income test.

Unlike C Corporations, the income of an S-Corp is generally subject to only one level of taxation. The income of the corporation is taxed only to the Corporation's shareholders.

The shareholders can deduct their share of the corporation's net operating loss on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation's earnings. S corporations serve as excellent vehicles for splitting income among family members through gifts or sales of stock

Although S Corporations are small business corporations, the sale of stock in an S Corporation does not qualify for tax exclusion for up to 50% of the gain on the sale of stock.

Compared to shareholder-employee of a C Corporation, the shareholder employee of an S Corporation are provided fewer tax free fringe benefits. Estate planning for shareholders is generally more complicated. Some of the tax advantages of Employee Stock Ownership Plans are not available to S corporations.

The states are not uniform in their treatment of S corporations. A majority of the states closely follow the federal approach, resulting in no state-level corporate tax. Instead, the shareholders are subject to individual income taxes, often in each state where the corporation does business. There are, however, numerous exceptions to federal conformity such as District of Columbia which does not recognize the special federal tax treatment of S corporations and tax them as regular corporations. Other states have adopted their own S corporation rules that differ significantly from the federal rules, thereby affecting not only the S corporation entity but also its shareholders.