S Corporation Facts

S corporations are similar to LLCs in that they provide owners with limited liability protection while offering the tax structure of a partnership.

Many entrepreneurs have two goals when choosing a structure for their business: Protecting their personal assets from business claims (limited liability) and having business profits taxed on their individual tax returns. Not long ago, an S corporation was the only choice for these business owners. In the last few years, however, the popularity of S corporations has plummeted as limited liability companies (LLCs) have largely replaced them. Still, S corporations are appropriate for some businesses. If you're interested, read on.

What Is an S Corporation?

An S corporation is a regular corporation that has elected "S corporation" tax status. An S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner.

In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money that they draw from the corporation as salary, bonuses, or dividends.

By contrast, in an S corporation, all business profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs). The S corporation itself does not pay any income tax, although a co-owned S corporation must file an informational tax return like a partnership or LLC -- to tell the IRS what each shareholder's portion of the corporate income is.

Should You Elect S Corporation Status?

Operating as an S corporation rather than a regular corporation may be wise for several reasons:

• An S corporation generally allows you to pass business losses through to your personal income tax return, using it to offset any income that you (and your spouse, if you're married) have from other sources.
• When you sell your S corporation, your taxable gain on the sale of the business can be less than if you operated the business as a regular corporation.
• S corporation shareholders are not subject to self-employment taxes (active LLC owners are).

Aside from the benefits, S corporations impose strict requirements. Here are the main rules:

• Each S corporation shareholder must be a U.S. citizen or resident.
• S corporations may have only one hundred shareholders.
• S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
• An S corporation shareholder may not deduct corporate losses that exceed her "basis" in her stock -- which equals the amount of her investment in the company plus or minus a few adjustments.
• S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

Fortunately, a decision to elect to be an S corporation isn't permanent. If your business later becomes more profitable and you find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time.

How to Elect S Corporation Status

To be treated as an S corporation, all shareholders must sign and file IRS Form 2553.

S Corporation Alternatives

You can accomplish the simultaneous goals of limited liability and pass-through taxation by creating a limited liability company (LLC). Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and because LLCs aren't subject to the many restrictions of S corporations, forming an LLC is often the better choice.

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