Q: What is an S-Corporation? Why choose S-Corporation Status?
First of all, S-Corporation is not an entity type. It’s an election that needs to be made on Form 2553, Election by a Small Business Corporation. An LLC or a sole proprietorship can elect to file as an S-Corporation.
Q. When to make the S-Corporation election?
The filing must be made no later than 2.5 months after the start date of its tax year for the election to be effective at the beginning of the year.
Q. What are the requirements for S-Corporation status?
- It must be a domestic(U.S based) corporation.
- It cannot have more than 100 shareholders.
- Shareholders generally must be U.S citizens or U.S Residents( including green card holders). Non-Resident aliens cannot be direct shareholders in an S-Corporation.
- Individuals, certain kind of trusts, banks and estates or even certain tax-exempt corporations (such as a 501(c) (3)) can all be shareholders in an S-Corporation.
- Corporate Shareholders and Partnerships are generally excluded from becoming shareholders in an S-Corporation.
- On the other hand, an S-Corporation is allowed to own a partnership interest or own stock in a C-Corporation.
- Profits and Losses must be allocated to shareholders in proportion to each one’s interest in the business.
- All shareholders of an S-Corporation must give consent for the S election.
Q. What is the filing requirement for S-Corporations?
- An S-Corporation must file using Form 1120S. It is a ‘pass through’ entity, which means the corporation itself does not pay taxes on its own, rather the income, deductions and credits get passed down to the individual shareholders and are reported on Schedule K-1. The return must be dated and signed by an authorized corporate officer, or in certain instances, by a fiduciary such as a receiver, trustee, or assignee on behalf of the corporation.
- An S-Corporation is always required to file a tax return regardless of any income or loss.
- The filing requirements end only when the corporation is dissolved.
- The IRS mandates electronic filing for S-Corps with $10 million or more in assets that file 250 more returns of any type ( Forms W-2, Forms 1099, Schedules K-1) per year.
Q. When is the tax return due date?
The tax return is due on the 15th day of the 3rd month following the tax year end. For a calendar year S-Corp, the tax return due date is March 15th.
Q. What are the advantages of choosing the S-Corporation status?
- The S-Corporation is not subject to Social Security and Medicare taxes( also known as self-employment taxes) on pass through income.
- S-Corporations are not subject to double taxation as in the case of C-Corporations. S-Corps do not pay taxes of their own; the income/losses pass down to its shareholders and is shown on their individual tax returns.
- Income and losses get allocated prorate on a daily basis to each shareholder based on their ownership of all shares of an S-Corp.
- An S-Corporation can pay its shareholders a ‘reasonable’ salary. Self-employment taxes are paid only on his/her portion of the salary by the shareholder and not on the distributive allocation.
- Offers great protection for personal assets if shareholders keep their business and personal accounts completely separate.
- S-Corporations have an unlimited life period and transferability of shares is easy.
- Fringe benefits paid to employees who are not shareholders or who have ownership of less than 2% are generally deductible by the S-Corporation as a regular business expense. These benefits are also tax free to the employees.
- For shareholders having greater than 2% ownership or more, health insurance premiums paid on their behalf are 100% deductible by the S-Corporation as fringe benefits. However, they are reported as wages on the shareholder-employees’ Forms W-2 for income tax withholding purposes.
Q. What are the disadvantages of running an S-Corporation?
- It can have only 100 domestic shareholders.
- It cannot have non-resident aliens as shareholders.
- Only individuals, certain kind of trusts, banks and estates or certain tax-exempt corporations( such as 501(c) (3)) can be shareholders in an S-Corporation. Corporate Shareholders and Partnerships are generally excluded from becoming shareholders in an S-Corporation.
- It can generally have only one class of stock.
- Some states do not recognize the S-Corporation election.
- Shareholders that own more than 2% of the S-Corp stock may have to include fringe benefits on their W-2.
- S-Corps might also be responsible for Payroll taxes( if it has employees), Excise taxes( diesel fuel, gasoline, highway usage, indoor tanning and wagering activities), Franchise taxes and Penalties (such as late filing penalties) as well.
- Both ‘at risk’ and ‘passive activity’ rules apply to S-Corporations. There might be certain exceptions though. Check with your tax advisor on what possible limitations might apply to you.
- There are limitations to certain deductions on a shareholder’s individual return such as alimony.
- S-Corporations generally are required to use a calendar year for reporting profits and losses. Though they can make an election with the IRS to change to a fiscal year.
- Unlike a C-Corporation, S-Corps are not eligible for a dividends received deduction.
Q. What are the separately stated items in an S-Corporation return?
An S-Corporation not only reports profits and losses but needs to report a few items separately. Their tax treatment is unique and is taxed differently from ordinary income. These separately stated items include:
- Net Income or loss from rental real estate activity( rental income)
- Portfolio income or loss that includes interest income, dividend income and royalty income.
- Capital Gains or Losses
- Section 1231 gain or loss
- Charitable contributions
- Sec 179 expense deduction
- Foreign taxes paid or accrued
- Any business credits
- Non-business bad debts
- How to terminate or revoke an S Election?
Once the S election is made, it stays in effect until terminated. Election will terminate inadvertently or automatically in any of the following cases:
- The corporation no longer qualifies as a small business corporation.
- For each of the three consecutive tax years, the corporation has accumulated earning and profits and derives more than 25% of its gross receipts from passive investment income.
- The corporation creates a second class of stock( such as preferred stock and common stock)
- The shareholders willingly revoke the S-election.
- Any non-resident alien becomes a shareholder.
- Shareholder count exceeds 100. As an example, a married couple is seen as one shareholder. In case of a divorce, the two ex-spouses cause the shareholder limit to exceed 100.
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