S Corporation Taxes

An S corporation is a creature of the federal tax laws. For all non-tax purposes, it's treated as a regular corporation. So, to form an S corporation, you first have to incorporate your business under state law.

Then, you must file Form 2553, Election by a Small Business Corporation, electing to be taxed similarly to a partnership. This election preserves the corporation's limited liability under state law but avoids taxation at the corporate level. As a result, the annual income or losses of the S corporation are passed through to shareholders in much the same way that a partnership passes through such items to partners.

One way in which an S corporation differs from a partnership is that all S corporation profits, losses, and other items that pass through must be allocated according to each shareholder's proportionate shares of stock. For example, if you own 50 percent of the stock, you must receive 50 percent of the losses, profits, credits, etc. In a partnership, one partner can receive different percentages of different tax items, if the partnership agreement so specifies.

S corporation requirements. While the technical requirements to obtain S corporation status are restrictive, an S corporation is given significant flexibility in structuring its business operations. For example, by forming a partnership that includes S corporations, ineligible shareholders can participate as partners in the corporation's business without the risk of losing the S election. Also, business owners that "outgrow" their S corporation status are always free to choose an alternative entity structure that better meets their needs. To obtain S corporation status under the federal income tax law, all of the following requirements must be met:

• The corporation must be a domestic corporation (a corporation organized under the laws of the United States, a state, or territory that is taxed as a corporation under local law).
• All shareholders must agree to the election.
• The corporation may not have more than one class of stock, however, voting and nonvoting shares are permissible.
• The corporation may not have more than 100 shareholders.
• The corporation may not have any shareholder that is a nonresident alien or nonhuman entity (such as other corporations or partnerships), unless the shareholder is an estate or trust that is authorized to be an S corporation shareholder under the tax laws. Certain exempt organizations, such as qualified pension, profit-sharing, and stock bonus plans, or charitable organizations will be allowed to be shareholders in an S corporation (for purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder counts as one shareholder).
• As of 1997, an S corporation can hold qualifying wholly owned subsidiaries and can own 80 percent or more of the stock of a C corporation. The C corporation subsidiary can elect to join in the filing of a consolidated return with its affiliated C corporations, but the S corporation cannot join in the election.