S corporation definition
/What is an S Corporation?
An S corporation is a corporate entity that passes its income through to its owners, so that the entity itself does not pay income taxes. The owners report the income on their tax returns, thereby avoiding the double taxation that arises in a regular "C" corporation. In effect, an S corporation entitles shareholders to the protections of incorporation while avoiding double taxation.
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Advantages of an S Corporation
There are multiple reasons why the owners of a business would want to structure it as an S corporation. Consider the following advantages:
Asset contributions. Under certain conditions, a taxpayer can contribute assets to an S corporation, tax free.
Create capital gains with borrowed funds. A business may want to create capital gains in order to offset capital losses that would otherwise have to be carried forward. One way to do so uses the unique structure of an S corporation, where any distribution in excess of a shareholder’s basis will generate capital gains. This can be done by having the S corporation borrow money (probably secured by company assets) and then distribute the borrowed funds to the shareholder. As long as this distribution exceeds the shareholder’s basis, it is considered a capital gain, and so can be used to offset the shareholder’s capital loss.
Distribute appreciated property. A distribution of appreciated property by an S corporation to its shareholders generates a gain in the amount of the difference between the corporation’s basis in the asset and its fair market value. This gain increases the basis of the shareholders’ stock in the corporation.
Distributions are free of payroll taxes. Any distributions made from an S corporation to shareholders are not subject to payroll taxes. This means that social security, unemployment, and Medicare taxes are not paid on these distributions.
Double taxation circumvention. The earnings of an S corporation are only taxed once, at the level of its shareholders. This is significantly better than for a C corporation, where the corporation is taxed and then again when any distributions to shareholders are taxed.
Immediate loss deductions. It is especially useful to employ an S corporation for a startup business, since the usual startup losses can be deducted, though it is capped at the amount of the shareholder’s basis in the corporation’s stock and the amount of any loans to it. Any losses in excess of the shareholder’s basis can be rolled forward to a later period, when the shareholder’s basis may have increased.
No accumulated earnings tax. An S corporation is not subject to the accumulated earnings tax, which applies to a C corporation if it accumulates an excessive amount of earnings without paying some portion of it to shareholders.
Passive loss offsets. If a shareholder does not actively participate in managing the business, any income passed through from it is characterized as passive, and so can be used to offset passive losses.
Shareholder protection. As is the case with any corporation, an S corporation shields its shareholders from the debts of the corporation.
Single taxation level on sale of business. When an S corporation is sold, the shareholders will pay tax on the distribution. This is better than for a C corporation, where tax is paid by the corporation and again by the shareholders when the proceeds are forwarded to them.
Disadvantages of an S Corporation
Despite the advantages listed earlier, converting from a C corporation to an S corporation does not always make sense – or it at least requires consideration of certain issues. In particular, the following concerns may be present:
Method of accounting. An S corporation cannot adopt a method of accounting that differs from the method previously used when it was a C corporation, unless it first gains the assent of the IRS.
Minimal cash retention. It is difficult for an S corporation to build up cash reserves, since its shareholders need distributions in order to pay taxes on the income that has been passed through to them.
Net operating loss carryforwards. It is not allowable to carry forward net operating losses (NOLs) from a C corporation to an S corporation, which can be a significant concern when an NOL is quite large.
Passive investment income. When a C corporation converts to an S corporation, it may fail the test if it had gross receipts of more than 25% from passive investment income in each of the past three years. The C corporation can eliminate this problem by declaring a dividend prior to the S corporation election that flushes out this income.
Record keeping. The S corporation accountant must maintain records for the basis in its shareholders’ stock. This is needed to determine the taxability of distributions, as well as to maintain the accumulated adjustments account.
Taxable built-in gains. A tax is imposed if an S corporation sells or distributes to its shareholders any assets that appreciated in value before the firm converted to an S corporation. The tax applies to any asset sales or distributions that arose during the five years prior to the date of the conversion to an S corporation.
Tax-free fringe benefits. Some tax-free fringe benefits (such as accident and health insurance premiums) are not available to the shareholders in an S corporation that hold more than a 2% interest in the business. When an S corporation pays for these benefits, they are treated as wages, which means that payroll taxes will be applied to them.
Unplanned termination. A dissident shareholder can trigger the termination of the entity’s S status by transferring shares to an entity that is not allowed to be a shareholder, such as a nonresident alien.
Increased compensation scrutiny. The officers of an S corporation can game the system by paying themselves a relatively low salary, which reduces the amount of payroll taxes paid. For this reason, the IRS is more likely to examine compensation levels, and may reclassify an S corporation’s earnings as wages; doing so can substantially increase the corporation’s payroll taxes.
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