What is the S Corporation (S Corp)?
S corporation refers to the special status entity exempted from paying corporate tax which allows shareholders to be taxed only once when they receive the benefits by follow-through taxation, thereby avoiding double taxation at the corporate level under a special chapter of IRS so that all the rules specified in the chapter shall be complied with.
There are different types of business entitiesTypes Of Business EntitiesA business entity is one that conducts business in accordance with the laws of the country. It can be a private company, a public company, a limited or unlimited partnership, a statutory corporation, a holding company, a subsidiary company, and so on. formed for conducting trade or business. Business entities are categorized by the structure of their business. An S Corporation is one such category of business entity. The name simply stands for ‘’small business corporation’’. The structure or features of a businessStructure Or Features Of A BusinessBusiness structure is the legal framework adopted by a company to execute business activities in compliance with the corporate rules and regulations. An organization can be a sole proprietorship, partnership, limited liability company or corporation. entity help distinguish it from other types.
Key Features of S Corporation
To begin with, the study let us first understand some of the basic features of the S corp. Mentioned below are the following key features:
- The entity must be a “domestic corporation”. A domestic corporation refers to an entity that cannot have non-resident shareholders as its owners.
- An entity must be having its shareholders to be less than or equal to 100.
- All shareholders must be individuals. However, there are certain aspects to this requirement that need to be discussed further.
- Trusts and estates that are considered as charity organizations and which get exemptions from taxation and can be considered as a shareholder.
- Partnerships or other corporations are not eligible to be shareholders. Family members are treated as a single shareholder in S corp. This implies that spouses or individual descendants of the elected shareholder will be considered as a single shareholder.
- An entity that owns one class of stock (This simply means profits and losses are distributed to owners/ shareholders in proportion to their interest in the business).
The entity must comply with all such requirements as listed above. In the event it fails to do so, the entity will no more be granted the S corp status.
Losing S Corporation Status
- There are various scenarios under which an entity can lose this status. Let us look at a particular case as S Corporation examples.
- Suppose, for instance, if any one of the shareholders elected is a “foreign national” i.e. a non-U.S resident or if the number of shareholders exceeds 100 due to the transfer of shares to a new shareholder then the entity stands to lose its S corp status.
- Now that we have listed down the features of an S corp, let us dive deeper into the concept of what an S corp actually means.
The Meaning of S Corporation Status
- The “Internal Revenue System (IRS)” that is the sole tax collection agencyCollection AgencyA collection agency refers to a firm engaged in the recovery of the default loans or dues from the borrowers on behalf of the lenders or creditors. A loan provider or creditor outsources its debt-collection function to such a third party to reduce bad debts. in the U.S enforces the Internal Revenue Code (IRC) on corporations.
- For S Corporation tax purposes, IRS categorizes corporations based on certain requirements. These requirements are nothing but the features listed above that qualify an entity to be accepted as an S corp.
- One of the major of S corporation advantages enjoyed by an S corp is that it is not subject to income taxes.
- This is subject to taxation similar to partnerships wherein all income or losses is shared among all its owners or shareholders. This implies that the IRS taxes such entities at the shareholder level and not at the corporate level.
To understand this further, let us look at the S Corporation examples.
Let’s suppose, an entity “ABC Inc” is an S corp with three shareholders and in the year 2016. In the year 2016, it earns a profit worth $10 million. Each one of the three shareholders, depending on the percentage of shares owned by them initially, will draw incomes equivalent to that percentage.
In this case, let us say that Sam, Todd, and Sara own 20%, 30% and 50% of shares, respectively. Given that ABC Inc is an S corp, the profits earned will not be reported to the IRS at the company or corporate level, instead, they will report at the individual shareholder level. Each one of the three shareholders will report this profit while filing their individual income tax returns. Hence, Sam, Todd, and Sara will report $200,000, $300,000 and $ 500,000 for their incomes, respectively.
Similarly, let’s consider S corporation examples when the company is making a loss.
If ABC Inc were to undergo losses of a certain amount, all three shareholders would have to file for losses on their personal incomePersonal IncomePersonal income refers to the total earnings of the individuals and households of a nation through multiple sources such as salary, wages, business profits, bonus, investment returns, dividends, rental receipts, employer contribution in provident or pension funds, etc. tax returns in the same proportion of shares owned by them.
Another major of S corporation’s advantages of being is that such entities can avoid double taxationAvoid Double TaxationDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.. Given that S corporation tax at the shareholder level, as explained above and not at the corporate level, This will pass on income directly to its shareholders and only income is given out as salaries to shareholders is subject to taxation. Other types of business entities do not enjoy this advantage, because any income/profit earned is filed and taxed at the corporate level, following which the net income/ profit is distributed to the shareholders who are in turn taxed on their earnings. This constitutes double taxation. Therefore, for small businesses, it is advantageous to register as an S corp to enjoy the tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. associated with it.
To summarize S corporation advantages, let us list them below as:
- S Corporation Tax is paid at the shareholder level and not at the corporate level.
- Double taxation is eliminated as income is only reported on individual tax returns of the shareholders.
- New businesses registered as S corp save on corporate taxesCorporate TaxesCorporate tax is a tax levied by the government on the profits earned by a company at a fixed rate each year and is calculated in accordance with specific tax regulations., as the corporation does not pay taxes at the corporate level.
- Shareholders can also be employees of the company, receiving salaries and dividends that are tax-free.
S Corporation Video
This has been a guide to what is S Corporation? Here we discuss key features of S Corporation, along with its advantages and practical examples. You may have a look at these articles below to learn more about Corporate Finance –