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Tax Tip: The Ups and Downs of S Corporations

Posted: October 15, 2013, 12:15 p.m. EDT

By Mark E. Battersby

Although the majority of United States businesses are organized for tax purposes as sole proprietorships, business owners are choosing more frequently to incorporate their businesses. One reason is that corporate form generally shields shareholders from business liabilities.

One of the best features of the S corporation is the tax savings for both the business and its shareholders. The main reason for this is that federal income tax does not normally apply at the entity level. Rather, income gains or losses are taken into account for tax purposes by the partners or S corporation shareholders on their personal tax returns. By contrast, a regular C corporation (which is not a pass-through entity like a sole proprietorship, a partnership, an LLC and an S corporation) is taxed separately on its income, and shareholders are taxed separately on distributions made by the corporation.

Another major difference between a regular corporation and an S corporation is that the latter can issue only one class of stock despite the limit of having up to 100 shareholders. Experts say this can hamper the operation’s ability to raise capital.

An S corporation designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the business, or sells his or her shares, the S corporation can continue doing business relatively undisturbed.

While "members” of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S corporation shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution,” which is taxed at a lower rate, if at all.

On the downside, S corporations are subject to many of the same requirements that corporations must follow, resulting in higher legal and accounting fees. The S corporation also must file articles of incorporation, hold directors and shareholders’ meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions.

All states do not tax S corporations equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. Some, such as Massachusetts, tax S corporations on profits above a specified limit. Other states don’t recognize the S corporation election and treat the business as a regular C corporation with all of the tax ramifications. Some states, such as New York and New Jersey, tax both the S corporation’s profits and the shareholder’s proportional shares of the profits.

If this unique pass-through corporation status is deemed advisable, a business owner is required to file a Form 2553 to elect "S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect. Obviously, professional advice is strongly recommended.



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