Guide to Operating an S-Corporation: Overview

By | November 15, 2007

An S-Corporation is a type of corporation that is recognized by the U.S. Internal Revenue Service and is treated differently than other corporations in terms of Federal taxation. Some states also recognize S-corporation status for state income taxation purposes; some states do not. The only reason for becoming an S-corporation is to obtain a different method of taxation than other corporations.

For standard corporations, the corporation pays a Federal and, perhaps, state corporate tax on the business profits. If the after-tax profit is distributed to the shareholders as dividends, the shareholders then pay an additional personal income tax on the dividends. The amount distributed to the shareholders as dividends is not a deduction for the corporation. S-corporations, on the other hand, are taxed similarly to partnerships. They act merely as a conduit for passing the income and deductions of the corporation directly to the individual shareholders in much the same manner as partnerships, or even sole proprietorships. The S-corporation does not pay a corporate tax and files a different type of tax form than does a standard corporation. (Please see our Taxation of S-Corporations Kit, available at Taxation of the profits of the S-corporation falls to the individuals who own shares in the corporation. This also allows for each individual shareholder to personally deduct their share of any corporate losses.

There are, however, certain basic requirements for qualifying a corporation with the IRS for S-corporation status. Every requirement must be met before the IRS will recognize S-corporation status and allow for the different tax treatment.

  • The corporation must have no more than 75 shareholders. (Wives and husbands, even if they own stock separately, are considered as only one shareholder)
  • Each of the corporation’s shareholders must be a natural person or the estate of a natural person. Corporations and partnerships may not hold shares in the corporation. Each shareholder must also be a citizen or resident of the United States
  • The corporation must have only one class of stock that is issued and outstanding. The corporation may have other classes of stock that are authorized, providing no shares are issued. Different voting rights within a class of stock (i.e. voting and nonvoting) do not disqualify the corporation
  • The corporation must already be incorporated in the United States or one of its possessions. Financial institutions, foreign corporations, and certain other very specialized corporations are not eligible
  • The corporation must not have been qualified as an S-corporation within the previous five years. This restriction prevents abrupt shifting from one type of corporation to another in order to obtain the maximum tax benefits
  • The corporation has a calendar tax year or has been approved by the IRS to have a tax year ending other than on December 31
  • All shareholders consent to the election of S-corporation status on IRS Form 2553: Election by a Small Business Corporation which must then be filed with the IRS

If your corporation meets all of these requirements, S-corporation status may be elected. It may be prudent to obtain the advice of a competent accountant prior to making the election, however. The actual steps in electing S-corporation status are detailed at the end of this kit in the S-Corporation Checklist. Please note that IRS Form 2553: Election by a Small Business Corporation (and all other IRS forms) can be easily downloaded from the IRS website.

The corporate business structure has three levels: shareholders, directors, and officers. In order to understand the requirements for corporate recordkeeping, it is necessary to understand how a corporation actually functions. Each level has different rights and responsibilities. Each level also generates different types of paperwork. Although all three levels of corporate management may often work together and may even be the same individual, the levels must be treated as separate parts of the corporate structure.

Learn more about S-Corporation Shareholders, Directors and Officers  by reading our Operating an S-Corporation Category.

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