Several benefits exist for filing an S corporation for a small business. S corporations enjoy flow through taxation, after deduction of “reasonable necessary business expenses”, which means the shareholders report taxes or tax losses on their personal income (see K1 forms). An S corporation also limits shareholder liability by placing what is called a “corporate shield” between the shareholders and the corporation. To start an S corporation in California, you must incorporate with the California Secretary of State.
S corporations are merely corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. For Federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level.
In order to make an election to be treated as an S corporation, the following requirements must be met:
- Must be an eligible entity (a domestic corporation, or a limited liability company which has elected to be taxed as a corporation).
- Must have only one class of stock
- Must not have more than 100 shareholders.
- Shareholders must be U.S. citizens or residents aliens, and must be natural persons. However, certain trusts, estates, and tax-exempt corporations, notably 501(c) (3) corporations, are permitted to be shareholders.
- Generally, profits and losses must be allocated to shareholders proportionately to each one’s interest in the business.
If a corporation that has elected to be treated as an S corporation ceases to meet the requirements, the corporation will lose its S corporation status and revert to being a regular C corporation.
The S election affects the treatment of the corporation for Federal income tax purposes. The election does not change the requirements for that corporation for other Federal taxes such as FICA and Federal unemployment taxes.
As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders. Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may re-categorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for the services they perform in their positions within the company.
Actual distributions of funds, as opposed to distributive shares, typically have no effect on shareholder tax liability. The term “pass through” refers not to assets distributed by the corporation to the shareholder, but instead to the portion of the corporation’s income, losses, deductions or credits reported to the shareholder on Schedule K-1 and are shown by the shareholder on his or her own income tax return, on an annual basis.