Within the family of corporations, the Internal Revenue Service (IRS) grants tax free status to S-Corporations. It is strictly an IRS term. In the IRS code, there are several subchapters pertaining to corporations; Subchapter S identifies and regulates S-Corporations. In essence, S-Corporations are a pass through entity meaning that all income, losses, credits and special deductions are pass-through to the stockholders of the company.
So how do you become an S-Corporation? How does the IRS deal with this type of entity? And finally what are the advantages and disadvantages of being an S-Corporation? The following sections describe in detail and explain the answers to these questions.
How Do You Become an S-Corporation?
All the states in the Union determine how an individual or a group of individuals incorporate their business. The IRS grants permission to the company to exist as an S-Corporation. The first step in this process is that the business must be incorporated under the state guidelines or regulations governing this business entity. Once incorporation is granted, the shareholders seek permission from the Internal Revenue Service for S-Corporation status under Code Section 1362.
The shareholders of the company seek permission as an S-Corporation by filing Form 2553 ‘Election by a Small Business Corporation’. This form is the application to the IRS seeking status as a pass-through entity, S-Corporation. Each shareholder identifies himself by notifying the IRS of their respective share of ownership and declaring their Social Security Number.
The respective tax year is identified. The IRS generally requires S-Corporations to have calendar tax years to match individual tax years. If the company seeks a tax year other than a calendar year, there must be some form of substantial reason to support this election. In general, the IRS will deny the application without substantial justification. Examples of substantial justification include seasonal variances such as seafood related industries or farming industries, limited duration companies, or ownership in excess of 100 shareholders. The other than calendar tax year exception is rarely granted.
The business operation should have less than 100 shareholders, have a calendar tax year, and be a domestic corporation. You must file Form 2553 within 75 days of the beginning of the calendar year to get granted rights to file a tax return as an S-Corporation for the same year.
Form 1120-S is filed for the company and a K-1 is provided to each shareholder of the company identifying the respective taxable income, deductions, and corresponding special items (charity, Section 179 deductions, Meals and Entertainment etc.). The company must file Form 1120-S by March 15 of each year for the prior calendar year. The business operation may seek a 6 month extension to file the return. It is generally granted to the applicant.
IRS Compliance and Interaction
When S-Corporation status is granted, the IRS is essentially telling the shareholders that we will allow you to exist as a corporation and get taxed at the individual level. This is known as a pass-through tax entity. All net income, deductions and credits are assigned to the shareholders at the individual level based on their respective percentage of ownership. The information is reported via Schedule K-1 1120-S. See What is a K-1? for more information about this particular schedule used by the IRS.
The S-Corporation must stay in compliance with some fundamental requirements. They include:
1. One Class of Stock – As companies grow, they often issue different classes of stock and preferred stock. As an S-Corporation, only the initial class of stock is allowed. Any additional class of stock or perceived class of stock through some other business instrument is immediate termination of S-Corporation status.
2. Shareholder’s Services – Shareholders providing services as an employee must be paid reasonable compensation – often tax advisors and friends advise owners of S-Corporations to pay themselves less money and therefore avoid employment taxes associated with those wages. For more information on employment taxes see: Form 941 – The Basics. Naturally the bottom line of the business tax return increases forcing the owner(s) to pay income taxes on this increased amount which negates the income tax reasoning. However, the employment taxes are reduced via this scheme to reduce overall taxation. The IRS looks at the compensation package of the owner(s) and the services they render to determine via a test of reasonableness that wages were appropriate. If determined otherwise, the company will most likely lose its S-Corporation status.
3. Health Insurance Premiums Paid on Behalf of Shareholders – Any premiums paid for health insurance on behalf of a more than 2% shareholder are considered wages paid to that shareholder. The shareholder is allowed to take the health insurance premium payment as a deduction in the adjustments section of Form 1040. Non- compliance risks termination as an S-Corporation.
4. Passive Income Greater Than 25% of Gross Receipts – If the company has accumulated earnings and profits at year end and passive income (dividends, rental income, royalties etc.) exceed 25% of the total gross receipts, the company must pay an income tax on the excessive amount. Failure to comply will result in termination of the S-Corporation status. Seek guidance from your CPA if you feel that passive income is in excess of 25%.
The IRS requires the shareholders to communicate stock and debt basis on an annual basis. This is customarily done via the K-1. However, any distributions and/or constructive dividends must be reported to the IRS and if considered income, must be reported on your Form 1040. Interacting with the IRS is done via the tax filing and immediate response when the IRS sends notices or requests for further information. This is considered good citizenship and is fairly easy to maintain.
Advantages and Disadvantages of S-Corporations
The number one reason shareholders elect status as an S-Corporation is to reduce the overall income tax. This is achieved by eliminating taxation at the corporate level and assigning the income tax on the net income to the shareholders on an ownership percentage basis. Another advantage is the reporting element to the Internal Revenue Service. In general, the Form 1120-S is simpler to prepare than partnership returns or some corporate returns.
Although the primary reason for S-Corporation status is to reduce taxation, there are a multitude of disadvantages associated with being an S-Corporation. They include:
- Once Class of Stock – this may appear as mute at first, but if the company grows and prospers, other classes of stock may need to be issued to entice investment into the company. So for the purpose of the small business entrepreneurship, this should not prevent an owner from seeking S-Corporation status but will become a concern as the company maturates.
- Health Insurance Compliance – this makes the paperwork aspect of business a little more difficult, but keeping good records and including corporate paid premiums for the shareholders as W-2 income will keep the company in good graces with the IRS.
- Allocating Income and Losses – this is one disadvantage that is very difficult to get around in dealing with the IRS. Partnerships can assign income and losses to the partners without restrictions, whereas an S-Corporation can only assign income and losses based on the percentage of ownership. This can be expensive if the company has a lot of net income and owners with significantly different tax rates.
- Limited to 100 Shareholders – in most situations, this is not an issue. Most small businesses are family owned and therefore there is not a large pool of investors or owners. However, if a company were to pursue significant growth, ownership will expand via stock sales and this could become a potential hang-up in the overall taxation status.
In general, the reduced taxation outweighs the disadvantages of the S-Corporation status. To the writer, the only real disadvantage is the allocation of income and losses. In partnerships, this is an advantage that if properly exercised will reduce the overall taxation for the owners more than the tax advantage of an S-Corporation. See Basic Principles of Partnerships for more information and guidance.
When considering status as an S-Corporation the owner(s) should address the pros and cons. Look at other possibilities. Based on my experience, any form of IRS entity status if properly executed and documented can control the overall taxes paid. This is a lifetime concept and future articles will articulate how this is done and carried out. For the reader, don’t just jump into this form of entity status because everyone is doing it or all my friends tell me it’s the best tool. Get some good advice and read more about the subject. In general, it is a good form of taxation reduction but as an owner you need to look at the whole picture. This includes where you want to take your business and you need to consider the impact upon other members of your family and employees. Keep on learning. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.
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