S Corporation

Definition

An S Corporation is a special type of corporation that allows income, deductions, and tax credits to pass through to shareholders, avoiding double taxation. This structure combines the legal protections of a corporation with the tax benefits typically associated with partnerships. It's particularly beneficial for small businesses looking to limit their liability while also enjoying favorable tax treatment.

5 Must Know Facts For Your Next Test

1. To qualify as an S Corporation, a business must meet specific IRS requirements, including having no more than 100 shareholders and all shareholders being U.S. citizens or residents.
2. S Corporations can only issue one class of stock, which limits their ability to attract certain types of investors compared to C Corporations.
3. Shareholders in an S Corporation can avoid self-employment taxes on distributions received from the company, making it a tax-efficient option for business owners.
4. Unlike C Corporations, S Corporations cannot have non-resident aliens as shareholders or corporate shareholders, which restricts ownership options.
5. If an S Corporation fails to meet the eligibility requirements, it may lose its S status and revert to being taxed as a C Corporation.

Review Questions

• How does the tax treatment of an S Corporation differ from that of a C Corporation?
  • The main difference in tax treatment between an S Corporation and a C Corporation lies in how they are taxed. An S Corporation allows income and losses to pass through directly to shareholders' personal tax returns, avoiding double taxation at both corporate and individual levels. In contrast, a C Corporation is taxed separately on its profits at the corporate level and then again at the shareholder level when dividends are distributed, leading to double taxation.
• What are some limitations that come with forming an S Corporation compared to other business structures?
  • S Corporations have specific limitations that businesses should consider before choosing this structure. For instance, they can only have up to 100 shareholders and cannot include non-resident aliens or corporations as shareholders. Additionally, they are restricted to issuing one class of stock, which may affect fundraising efforts. These limitations could make S Corporations less attractive for businesses planning to seek extensive investment or have diverse ownership.
• Evaluate the advantages and disadvantages of electing S Corporation status for a startup considering long-term growth and funding opportunities.
  • Electing S Corporation status offers several advantages for startups, including pass-through taxation, which can save money on taxes, and limited liability protection for owners. However, these benefits come with trade-offs such as restrictions on shareholder composition and stock classes, which may hinder access to capital and growth opportunities. As a startup considers long-term growth, it’s crucial to weigh these factors carefully against potential funding needs and investor interests in order to determine if an S Corporation is the right fit for their business model.

Related terms

C Corporation: A C Corporation is a standard corporation that is taxed separately from its owners under Subchapter C of the Internal Revenue Code, leading to potential double taxation on corporate profits.

Limited Liability Company (LLC): An LLC is a flexible business structure that combines the liability protection of a corporation with the tax benefits of a partnership, allowing for pass-through taxation similar to an S Corporation.

Pass-Through Taxation: Pass-through taxation is a tax treatment in which business income is reported on the individual tax returns of the owners, avoiding the double taxation that corporations face.