A Subchapter S Corporation (“S-Corp”) is a corporation organized under state law but receives special tax treatment under the Internal Revenue Code (“IRC”). Under the IRC, an S-Corp is a tax-reporting entity but not a tax-paying entity. This means that when the corporation realizes profits the corporation will incur no tax liability. Only the corporate shareholders will pay taxes on the income generated by the corporation, based upon their proportional share of stock ownership. For example, Shareholders X and Y each own 50% of the stock of Z Corporation, an S-Corp under federal tax law. Z Corporation generates $100,000 of corporate earnings and profits in tax year 2013. X and Y will report $50,000 of income on their respective 2013 tax returns.
Not every small business corporation will be eligible to make an S-Corp election, however. In order to qualify as an S-Corp, the following conditions must be met:
1. The business must be a domestic corporation with no more than 100 shareholders.
2. The shareholders must be individuals, trusts, estates, or tax-exempt organizations; no partnerships, Subchapter C Corporations, or limited liability companies.
3. All shareholders must be U.S. Citizens or legal permanent residents.
4. The corporation is permitted to issue only one class of stock, usually common, non-preferred voting stock.
5. There are significant restrictions on the type of debt instruments the corporation is permitted to issue.
Before making an S-Corp election under the IRC, it’s important to carefully consider whether you will be able to meet the requirements listed above, because the tax consequences of your corporation losing its S status can be severe.
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