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S-CORPORATIONS: Does It Stop "Double Taxation"?

The "S" corporation is a corporation like any other -- the "S" designation simply means that the corporation has elected (if qualified) a certain tax arrangement or treatment as compared to a corporation that does not make the "S" election. In other words, the "S" tax status election creates a special tax designation applied for and granted by the IRS to corporations that have already been formed. Before the "S" tax treatment can be chosen, the corporation must first be filed with the appropriate state agency. Because the "S" corporation is, first and foremost, a corporation in the eyes of the law, "S" corporation shareholders enjoy the shield or protection afforded by the corporate structure (i.e. no personal liability for business debt or obligations). The "S" tax treatment is obtained by properly and timely filing IRS Form 2553.

For most smaller and family-owned corporations, the "S" tax election is the preferred tax treatment. The S-Corporation can be a highly desirable entity for corporate tax purposes. The "S" status combines many of the tax advantages of a sole proprietorship, partnership and the corporate forms of business structure. To see the benefit of the "S" tax treatment, it is easiest to first take a look at the tax treatment of a corporation that does not elect the "S" status.

If a corporation does not elect "S" tax treatment (these corporations are known for tax purposes as "C" corporations), when and if a corporation earns a profit, the corporation pays a federal corporate income tax on that corporate profit - this is one layer of tax that must be paid. If the company makes a profit and then declares a dividend that is to be paid to the corporation's shareholders, these shareholders must then report the dividend as personal income and pay taxes on that money - this is the second layer of tax. Without making the "S" election, corporations and their shareholders are subject to two levels of taxation.

A corporation that properly elects "S" tax treatment avoids this "double taxation" by permitting all earnings and losses generated or incurred by the corporation to "pass through" directly to the shareholders - on their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss. While the corporation must still file a corporate tax return, the corporate profits or losses that are passed through to the shareholders are reported on the shareholder's personal tax returns and the shareholders pay tax on this passed through profit. This being stated, while the "S" corporation is exempt from federal income tax, the corporation may be obligated to pay tax on certain capital gains and passive income. Also, a corporation, even if electing "S" status, must still pay any employee withholding taxes, FICA, Social Security and excise taxes required by the IRS.

With this perceived benefit, it seems like every corporation would attempt to elect "S" tax treatment - but not all corporations can. In order to be eligible or qualified to elect "S" tax status or treatment, the corporation must comply with IRS and tax code rules, some of which are as follows:

* · There can be no more than 100 shareholders of the corporation.

* · All "S" Corporations must have shareholders who are citizens or legal residents of the United States.

* Shareholders must be individuals or estates (with some other limited exceptions) - no corporate shareholders.

* · "S" Corporations may only issue one class of stock.

* · Not all business corporations are eligible for "S" Corporation status: financial institutions that are a bank; insurance companies taxed under Subchapter L; Domestic International Sales Corporation (DISC); and certain affiliated groups of corporations.

The above list is illustrative only. There are other circumstances that may cause an "S" corporation to lose its "pass through" nature and to owe income tax.

Note that this article is not intended to provide any tax advice or direction.


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