S-Corporation Definition and Requirements
An S-Corporation is a regular corporation with between 1 and 100 shareholders that passes-through net income or losses to those shareholders in accordance with Internal Revenue Code, Chapter 1, Subchapter S. Corporations must meet specific eligibility criteria, and they must notify the IRS of their choice to be taxed as an S-Corporation within a certain period of time.
Taxation of Regular Corporations
Regular corporations, sometimes called a C-Corporations (after Subchapter C of the Internal Revenue Code) are taxed as separate business entities. C-Corporations have their own tax form (1120) and their own tax rates. They may choose to retain their profits and earnings as part of their operating capital, or they may choose to distribute some or all of their profits and earnings as dividends paid to shareholders.
Dividends paid to shareholders are taxed twice—once at the corporate level (on the corporation's Form 1120), and again at the individual level (on a shareholder's Form 1040).
Taxation of S-Corporations
S-Corporations are not subject to corporate tax rates and are exempt from federal income taxes except for certain capital gains and passive income, according to the IRS.
Instead, S-Corporations pass-through profits (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through nature of the income means the corporation's profits are taxed only once—at the shareholder level.
S-Corporations, like C-Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders. Therefore, an S-Corporation shareholder might be taxed on income never received because it was retained by the business. A shareholder of C-corporation, on the other hand, is taxed on dividends only when those dividends are actually paid out.
A corporation may choose to be taxed as an S-Corporation if it meets the following criteria:
- The company is (a) a domestic corporation, or (b) a domestic entity eligible to elect to be treated as a corporation that timely files Form 2553 and meets all the other tests listed below.
- The company has no more than 100 shareholders. (A husband and wife and their estates are treated as one shareholder for this test. A member of a family can choose to treat all members of the family as one shareholder for this test. All other persons are treated as separate shareholders.)
- The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.
- The company has no nonresident alien shareholders. (That is, the only shareholders are U.S. citizens and resident aliens.)
- The company has only one class of stock. Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation's stock confer identical rights to distribution and liquidation proceeds.
- It is not one of the following ineligible corporations:
- A bank or thrift institution that uses the reserve method of accounting for bad debts under section 585.
- An insurance company subject to tax under subchapter L of the Code.
- A corporation that has elected to be treated as a possessions corporation under section 936.
- A domestic international sales corporation (DISC) or former DISC.
- It has or will adopt or change to one of the following tax years.
- A tax year ending December 31.
- A natural business year.
- An ownership tax year.
- A tax year elected under section 444.
- A 52-53-week tax year ending with reference to a year listed above.
- Any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose.
Each shareholder consents to the S-Corporation election.