What Is an S corporation?
An S corporation is a pass-through entity.
The purpose of an S corporation is to provide shareholders the same limited liability protection that shareholders of a regular C corporation receive while treating the s corporation shareholders as if they were partners in a partnership for tax purposes; partners receive pass-through treatment of income, deductions, credits, losses, and gains.
What is a Pass-Through Entity?
A pass-through entity is a financial conduit from the entity to its owners.
- Income passes through the entity directly to S corporation shareholders, even if the income is not actually distributed to them
(referred to as undistributed earnings).
- The S corporation itself is not taxed. However, their are a few exceptions where an S corporation that previously operated as a C corporation for a length of time can be taxed.
- Losses, deductions, and credits are also passed through the entity to shareholders.
- S corporation shareholderss include their proportionate share of income, deductions, credits, gains, and losses passed through to them on their individual income tax returns via Schedule K-1, which is issued to each shareholder annually by the s corporation. For example, if the s corporation has two shareholders who each own 50% of the stock, then each shareholder reports 50% of each pass-through item on his/her individual income tax return.
- S corporation stockholders get to deduct S corporation losses from their other sources of income (e.g., wages from a job, interest, dividends)
on their individual income tax return.
- It is this pass-through treatment of income that enables S corporations to avoid double taxation of income.
In other words, S corporation income is taxed only once, at the
individual tax level.
- Annually, an S corporation files Form 1120S and sends Schedule K-1 to each shareholder detailing his/her share of income, deductions, gains, losses, and credits.
S corporation shareholders are not personally liable for S corporation debts.
However, there is a caution here:
- Trust fund taxes:
- Limited liability will not shield shareholder/employees from liability for delinquent trust fund taxes
or any person with responsibility for the payroll tax withholding.
Trust fund taxes include:
- Federal income taxes required to be withheld from an employee's wages, plus
- The employee's share of social security and Medicare taxes.
Legal Status of an S corporation
The "S" in S corporation refers to the subchapter of the Internal
Revenue Code that governs its tax treatment for federal income tax purposes.
Making this election does not change the legal status of a business.
For example, although a C corporation and a limited liability company (LLC) may elect S corporation tax treatment by filing Form 2553 with the IRS, under state law, these entities retain their original legal status despite such election.
In other words, if a business starts out as a C corporation or LLC, state laws that apply to these business structures still apply
even if an election is made to be taxed as an S corporation.
An S corporation is generally required to use a calendar year (January 1 through December 31).
IRS approval is needed to adopt a different tax year.
S corporations: Advantages of an S corporation; Disadvantages of an S corporation