An S Corporation is a special type of corporation that meets specific Internal Revenue Code requirements, allowing it to be taxed as a pass-through entity, which means that income, losses, deductions, and credits flow through to the shareholders' personal tax returns. This structure provides the limited liability of a corporation while avoiding double taxation on corporate income, making it an attractive option for small businesses. The election to be treated as an S Corporation can influence its capital structure and tax implications, including restrictions on built-in gains and passive income.
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To qualify as an S Corporation, a company must have no more than 100 shareholders, all of whom must be U.S. citizens or resident aliens.
S Corporations can only issue one class of stock, which means all shares must have the same rights regarding distribution and liquidation.
The built-in gains tax applies to S Corporations that convert from C Corporations if they sell appreciated assets within five years of electing S status.
S Corporations face restrictions on passive income; if more than 25% of gross receipts come from passive income for three consecutive years, they may lose their S Corporation status.
Shareholders of S Corporations are subject to self-employment taxes on their wages but not on the distributions received from the corporation.
Review Questions
How does the structure of an S Corporation benefit small business owners compared to a C Corporation?
An S Corporation allows small business owners to benefit from pass-through taxation, meaning profits are taxed only at the individual level rather than facing double taxation as in a C Corporation. This structure helps reduce overall tax liability, making it financially advantageous for smaller companies. Additionally, owners enjoy limited liability protection similar to that of a C Corporation while avoiding many complexities associated with corporate taxation.
Discuss the implications of the built-in gains tax for an S Corporation transitioning from a C Corporation.
When a C Corporation elects to become an S Corporation, it may be subject to a built-in gains tax if it sells assets that have appreciated in value within five years of making the election. This tax applies to the net gain from the sale of those assets, and it can create significant tax liabilities that impact the financial planning of the S Corporation. Understanding these implications is crucial for shareholders when deciding whether to convert from C to S status.
Evaluate how eligibility requirements for S Corporations can influence strategic decisions for business owners considering this structure.
The eligibility requirements for S Corporations, including limits on the number and type of shareholders and restrictions on classes of stock, significantly impact strategic decisions for business owners. For example, the cap of 100 shareholders can limit growth and investment opportunities if the business plans to expand significantly. Additionally, since only certain types of entities can be shareholders (like individuals but not corporations or partnerships), business owners need to carefully consider their financing strategies and long-term goals when choosing this structure.
Related terms
Pass-Through Taxation: A tax structure where the income of a business is not taxed at the corporate level but instead passed through to the owners or shareholders who report it on their individual tax returns.
A standard corporation that is taxed separately from its owners, leading to potential double taxation on corporate profits and dividends paid to shareholders.