Many entrepreneurs have two goals when choosing a structure for their business: protecting their personal assets from business claims and having business profits taxed on their individual tax returns. Not long ago, an S corporation was the only choice for these business owners. In the last few years, however, the popularity of S corporations has dropped as limited liability companies (LLCs) have largely replaced them. Still, S corporations are appropriate for some businesses. If you’re interested, read on.

What is an S corporation?
An S corporation is a regular corporation that lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner.

In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money that they draw from the corporation as salary, bonuses or dividends. By contrast, in an S corporation, all business profits “pass through” to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships and LLCs). The S corporation itself does not pay any income tax, although a co-owned S corporation must file an informational tax return like a partnership or LLC — to tell the IRS what each shareholder’s portion of the corporate income is.

Most states follow the federal pattern when taxing S corporations: They don’t impose a corporate tax, choosing instead to tax the business’s profits on the shareholders’ personal tax returns. About half a dozen states, however, do tax an S corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

Should you elect S corporation status?
If your corporation meets certain criteria, such as having only shareholders who are U.S. citizens or residents, you can elect to do business as an S corporation. Operating as an S corporation rather than a regular corporation may be wise for several reasons:

  • An S corporation generally allows you to pass business losses through to your personal income tax return, using it to offset any income that you (and your spouse, if you’re married) have from other sources.
  • When you sell your S corporation, your taxable gain on the sale of the business can be less than if you operated the business as a regular corporation.

But aside from the benefits, S corporations impose strict requirements. Here are the main rules:

  • Each S corporation shareholder must be a U.S. citizen or resident.
  • S corporation profits and losses may be allocated only in proportion to each shareholder’s interest in the business.
  • An S corporation shareholder may not deduct corporate losses that exceed their “basis” in their stock — which equals the amount of their investment in the company plus or minus a few adjustments.
  • S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

Fortunately, your decision to elect to be an S corporation isn’t permanent. If you later find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time.

How to elect S corporation status
To be treated as an S corporation, all shareholders must sign and file IRS Form 2553. Shareholders then pay income tax on their share of the corporation’s income whether or not they actually receive the money. If the corporation suffers a loss, shareholders can claim their share of that loss.

S corporation alternatives
You can accomplish the simultaneous goals of limited liability and pass-through taxation by creating a limited liability company (LLC). Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and because LLCs aren’t subject to the many restrictions of S corporations, forming an LLC is often the better choice. (To learn more about limited liability companies, see “LLC Basics.”)

Consult an expert
Choosing an ownership structure for your business can be complicated. To find out whether an S corporation, a C corporation or an LLC is the best fit for your company, consult a tax lawyer or an experienced accountant who is knowledgeable about the tax advantages and disadvantages of the various types of ownership structures.

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