All corporations start out as C Corporations. In order to become an S Corporation a form needs to be filed with the IRS within 75 days of the start of business (or within 75 days of the corporate year for existing corporations). The S Corporation also offers the limited liability factor, but is also not a taxable entity at all. However, while the S Corporation is not taxed, the profits it generates, whether distributed or not, is taxable to the shareholders at their own personal tax rate. This means if the corporation decides to retain earnings, the shareholders are still taxed even though they received no dividends.
With this type of entity the shareholders are treated as if they were partners in a partnership. If the corporation is showing a loss, which could potentially be done three out of five years, this loss could flow through to the shareholders lessening their personal tax burden.
In recent years we have seen the LLC used in place of an S Corporation. In fact, it is thought that eventually the S Corporation will no longer be used and will simply be replaced by the LLC.
As with other types of entities, the S Corporation certainly has its place. It is appropriate for companies that are expecting a loss during the initial years of operation; companies that do not intend to go public in the near future; and companies that do not expect multiple classes of stock. Some disadvantages of an S Corporation are as follows.
- As mentioned above, the shareholders are subject to tax on retained earnings
- Not as many deductions available as with a C Corporation
- Usually must use a calendar year as opposed to a fiscal year
- Not recognized in every state
- If the S Corporation status is lost for any reason, it cannot be re-obtained for five years unless the corporation changes hands (Unless the IRS does it by accident, then you could sign a waiver and agree to pay necessary tax adjustments)
- Fringe benefits for shareholders must be reported as income if they own more than 2% of the stock
- The shareholder/employee can only deduct 25% of the cost of medical insurance as an adjustment to his/her income
- In some states it is subject to the same tax as a C Corporation
- Corporations and partnerships are not eligible to own stock in the S Corporation
- Shareholders must be revealed to the IRS to determine their Federal Tax Obligation
- Flow through of income or losses to shareholders
- No double taxation
- Liability limited to business assets
- Fewer tax deductions available than with a C Corp
- Election of S Corp status is limited
- Ownership restrictions apply