A corporation will, for tax purposes, be either a “C corporation” or an “S corporation.” In the majority of cases, it is more beneficial to the corporation and its shareholders to elect to be an S corporation. Before we discuss the benefits of an S corporation, however, we should look at the differences between the two types of corporations.
All corporations in the U.S. start out as C corporations for tax purposes. Some qualified corporations may elect to be S corporations (see discussion below), but the election is not automatic and it does not take effect until it is accepted by the IRS.
A C corporation is taxed as an entity separate from its shareholders. It must pay income taxes on any profit that it makes. The shareholders also have to pay taxes on the corporation’s profits when they are distributed. (The profits may not be distributed to the shareholders in the year in which they are earned, for a variety of reasons.) This system results in double taxation, because the corporation’s distributions are treated as income to the shareholders, even though the corporation has already paid taxes on its profits.
S corporations are not subject to double taxation, because the corporation’s profits and losses flow through to the shareholders. The shareholders pay taxes on the profits in the year in which they are earned. If there are losses, the shareholders may offset the losses against current income. This system taxes the corporation’s profits like a partnership, and yet provides the legal advantages of a corporation.
As mentioned above, there are a number of restrictions on S corporations. To elect to be an S corporation, a corporation must:
- be a domestic corporation or a domestic entity eligible to be treated as a corporation
- not have more than 100 shareholders (husband and wife are treated as one)
- generally have only individuals as shareholders
- not have nonresident alien shareholders
- have only one class of stock
- not be an ineligible corporation, as defined by the IRS
- have a tax year ending December 31, or a different tax year approved by the IRS; and
- have each shareholder’s written consent
An S election is made by the filing of IRS Form 2553 with the IRS. The election will be accepted by the IRS only if all of the requirements in the preceding paragraph are met. The election should be filed no more than two months and 15 days after the beginning of the tax year for which it is to take effect, or at any time during the tax year preceding the tax year it is to take effect. The tax year of a newly formed corporation starts on the date that it has shareholders, acquires assets, or begins doing business, whichever happens first. If an election is filed late, it will be effective for the next tax year.
Illustration: If a corporation with a tax year beginning January 1 files Form 2553 in April, the S election will be effective for the corporation’s next tax year because it was filed too late to be effective for the tax year in which it was filed.
For more information on S corporations, the reader may wish to visit the IRS’s Web site, www.irs.gov. Instructions and forms concerning S corporations can be downloaded from the site.
The above article is an excerpt from Arizona Laws 101: A Handbook for Non-Lawyers, 2nd Edition (Fenestra Books, 2012), by Donald A. Loose, republished with the author’s permission.
Disclaimer: Laws change constantly. Specific legal advice should be obtained regarding any legal matter. The information contained on this website does not constitute legal advice and no attorney-client relationship is created.
Don likes to target shoot, scuba dive, and pilot airplanes. Most recently, he has been working on his golf handicap. Don enjoys writing, reading, and spending time with his wife, twin sons, and golden retriever, Lucy.