Deciding which type of corporation is the best for your business can be a confusing and tedious task. Two types of corporations are recognized by the Internal Revenue Service for the purpose of federal income tax imposition: C corporations and S corporations. An S corporation is a special structure of business ownership by which the business is able to avoid double taxation because it is not required to pay corporate income tax on the profits of the company. All profits/losses are passed on directly to the shareholders of the company. The shareholders file individual tax returns and pay income tax on whatever share of profits they receive from the business. If the business has more than one shareholder the business must file an informational tax return to provide details of the corporate income of each shareholder. This article will talk in detail about the positives and negatives of incorporating a company as an S corporation.

A business electing to incorporate with S corporation status has its business income taxed only once, similar to how sole proprietorships and partnerships are taxed. By electing to become an S corporation, a small business can avail the legal advantages available to businesses with a corporate structure as well as the tax advantages available to partnership firms. Such provisions have been made primarily in order to promote small businesses and relieve them from the financial burden of double taxation. A business wanting to take advantage of the tax benefits available to S corporations has to make an election for being treated like one. This election is made by filling out Form 2553 and submitting it to the Internal Revenue Service. The form requesting this election, duly signed by all shareholders, should be submitted on or before the 15th of March of the tax year from which a corporation elects to be treated as an S corporation. The business however must conform to certain set criteria before it can be accorded an S corporation status.

The relevant provisions containing details that also specify the criteria for S corporation eligibility can be found in Chapter 1, Subchapter S of the Internal Revenue Code. They state that in order to be eligible for becoming an S corporation a small business needs to have fewer than 100 shareholders. Every shareholder must be a US citizen or US resident. It is also required that all shareholders support an S corporation business structure. A business that elects to be treated as an S corporation is required be a domestic company located within any state in the US. Individuals, estates and selected types of trusts qualify for becoming shareholders of an S corporation. The S corporation can have only one class of stock. This can broadly be understood as all shares of the corporation conferring equal and identical rights on shareholders in terms of profit distributions and liquidation proceeds.
All criteria must be met right from the time of submitting form 2553 and should continue as such till the time the S corporation status is no longer desired. Any violation of any of the mandatory provisions results in an automatic and immediate termination of the S corporation election. Once this happens, the corporation acquires the status of a taxable entity. As mentioned earlier, S corporation election relates only to federal income tax. For the purpose of state income tax, it is essential to check with the taxation department of the concerned State to ascertain as to how that State treats the federal S corporation status for determining the State corporate income tax, as many States do not recognize it for the purpose of tax exemption.

Advantages of an S Corporation:
  • No Corporate Tax
  • Reduce Taxable Gains
  • Write off Start-up Losses
  • Liability Protection
Disadvantages of an S Corporation:
  • Limited to 35 shareholders
  • Can only use domestic capitalization
  • Shareholders pay taxes on all profits in the year earned, whether or not they are distributed.
  • Generally must operate on a calendar year
Choosing a business structure for your small business is never easy. It is advisable to acquaint oneself with the business of company formation and then make an informed decision in consultation with legal counsel that specializes in corporate law.