S-Corporation Basics

 

Many business owners ponder what type of business entity best fits their needs. Some advisors, such as attorneys, like limited liability companies (“LLC”) for start-up businesses. For other start-ups, an LLC is not the best entity, particularly when the business has investors. The pull between the owners and investors is two-fold: investors want to profit from the business, while the owners want profit with reduced taxation.

Enter the S-Corporation. At a very basic level, the S-Corporation combines some elements of a C-Corporation with some elements of a partnership. A main drawback to a C-Corporation is double taxation: C-Corporations have taxation at both the corporate level and at the shareholder level. An S-Corporation eliminates this double taxation by taxing only at the shareholder level: “Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.” Thus, S-Corporations are called “pass-through entities” since profits pass through the corporation directly to the shareholders, where taxation occurs only once, just as it would in a partnership.

There is a tradeoff: the government granted S-Corporations single taxation status, but placed limitations on S-Corporations such as the number of investors and classes of stock.

Shareholders and Stock

S-Corporations cannot have more than 100 shareholders. Each shareholder must be an individual (with some exceptions for an estate and certain trusts and organizations). Each shareholder cannot be a nonresident alien. Finally, the S-Corporation may not have more than one class of stock (although differences in voting rights amongst the stock is permitted).

Ineligible Corporations

There are further limitations placed on the types of corporations- S-Corporations cannot be ineligible corporations. Ineligible corporations include an insurance company subject to tax under subchapter L of the Internal Revenue Code, domestic international sales corporations, and other ineligible corporations.

Electing S-Corporation Form

The S-Corporation entity or opting to be taxed as a pass-thru entity offer several benefits to the shareholders, particular the elimination of the double taxation present in a C-Corporation. The limitations placed upon S-Corporations, though, can be cumbersome. Often, business owners run into problems with having too many shareholders, desiring more than one class of stock, or having a nonresident alien shareholder. These limitations become more problematic as the business grows.

If you are starting a business or unsure what the best entity is for your current business, please contact Benjamin Long of Schmidt & Long.