If you are thinking about starting a business, one of the first decisions that you will face is determining what kind of entity to use for the business. Many simple businesses can be operated as a sole proprietorship, with the income and expenses reported directly on the Form 1040. However, if there is more than one owner, consideration should be given to filing as a subchapter S corporation. An S corporation is a small business company that elects special tax status.
The major difference between a regular corporation and an S corporation is that S corporation income is subject to a single level of tax. Its income is passed through to shareholders and included on their individual income tax returns. The S corporation form combines the business and legal characteristics of a corporation, including limited liability, with many aspects of partnership taxations, but does not provide as much flexibility as an LLC.
There are a few instances in which the S corporation may pay tax at the corporate level. This may apply if the corporation was previously a C corporation or if the corporation engaged in a tax-free reorganization with a C corporation. The tax may be related to excess net passive income tax and/or LIFO recapture tax. (We strongly recommend talking to your Henry+Horne CPA for more information on this subject.)
To elect and continue S corporation status, the corporation and its shareholders must meet a number of basic requirements:
- Be a domestic corporation,
- Have no more than 100 shareholders,
- Have shareholders that are individuals (U.S. citizens), estates and certain types of trusts or exempt organizations described under section 401(a) or 501(c)3 in the IRS Code, and
- Have only one class of stock.
In addition to the above requirements, the entity cannot be:
- A bank or thrift institution that uses the reserve method of accounting for bad debts under Section 585,
- An insurance company subject to tax under Subchapter L of the Code,
- A corporation that has elected to be treated as a possession corporation under Section 936 of the Code, and
- It is a domestic international sales corporation (DISC) or former DISC.
Once a corporation is formed using legal services, a corporation elects to operate as an S corporation by filing Form 2553, Election by a Small Business Corporation. Once made, the S election remains in effect until it is voluntarily or involuntarily terminated. The deadline for filing the Form 2553 differs depending on whether the corporation is already in existence or newly formed. There is also relief for late S corporation filing elections available.
There are many other aspects of subchapter S corporation eligibility and operations that should be discussed with your Henry+Horne CPA when starting a new business. Good planning can alleviate any issues or hidden traps that arise after a business is operating.
Kelly Lynch, CPA