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An S Corporation is a Corporation that meets the organizational requirements in order to be taxed under Chapter S (formerly called Subchapter S) of the Internal Revenue Code. Because it qualifies as an S Corporation, this kind of Corporation is eligible to receive pass-through taxation benefits much like a Partnership. Pass-through taxation means that the income of the S Corporation is not assessed any Corporate taxes. Instead, the income or losses of the S Corporation are distributed among the individual shareholders in direct proportion to their ownership or investment in the company. This income or loss is then claimed on the individual tax returns of the shareholders as personal income, and it is taxed at a much lower rate than the Corporate tax assessment.
Differences Between a C Corporation and an S Corporation
The primary difference between a C Corporation and an S Corporation is that C Corporations are required to pay Corporate taxes first, and then the shareholders must also pay personal income tax on their percentage of that income. S Corporations, on the other hand, are not required to pay Corporate taxes.
The income generated by traditional C Corporations is first claimed on the U.S. Corporation Income Tax Return (IRS Form 1120) filed by the C Corporation and taxed at the Corporate Federal rate of 15-35%, depending on the amount of total taxable income. Then this income is distributed to the shareholders as dividends and must be claimed as earned income on the shareholders’ individual 1040 income tax returns where it is taxed again at the individual Federal and State rates. This “double taxation” is one of the disadvantages of a traditional C Corporation. S Corporations, however, are granted pass-through taxation privileges. This means that any income generated by an S Corporation is not subjected to taxation at the Corporate level. Instead, this income is distributed among the shareholders as dividends, claimed on their personal 1040 income tax returns, and is only taxed at the individual rate, depending on the total taxable income of the individual shareholder.
For example, Steve and Joe form Widget Inc. as an S Corporation and generate $20 million in income their first year. If Widget Inc. was a traditional C Corporation, that $20 million in Corporate income would be assessed 35% Corporate income tax, meaning Steve and Joe would owe $7 million in Corporate taxes! Then the remaining $13 million would be distributed to Steve and Joe as shareholder dividends according to their ownership percentage. Since Steve owns 51% and Joe owns 49% of the Corporate shares, Steve would receive $6,630,000 and Joe would receive $6,370,000. At the end of the year, both Steve and Joe would then have to claim this income on their personal tax returns and pay additional personal income tax!
However, since Widget Inc. was organized as an S Corporation, there are no taxes assessed at the Corporate level. The entire $20 million would be distributed to Steve and Joe, with Steve receiving $10.2 million and Joe receiving $9.8 million in Corporate dividends. At the end of the year, both Steve and Joe are still required to claim this income on their personal income taxes; however since they did not have to pay any Corporate taxes, their overall tax savings are incredible!
Requirements for S Corporation Status
The first requirement for the formation of an S Corporation is that the Corporation be formed as a for-profit, general C Corporation. It is also imperative that the Corporation has only issued one class of stock.
Another set of requirements for the formation of an S Corporation has to do with the shareholders themselves. S Corporations are typically limited to 75 to 100 shareholders who are all US Citizens or Permanent US Residents. Also, the passive income level of the Corporation must not exceed 25% of the gross receipts. Beyond that, the Corporation has 75 days from incorporating to file an Election by a Small Business Corporation (IRS form 2553).