Alphabetical differences

guest commentary by David Potts

S corporations are the most prevalent type of corporations. More than 60% of all corporate income tax returns filed with the IRS are S corporation returns. So then, what exactly is an S corporation and why are they so prevalent?

When a business incorporates it does not incorporate as an S corporation. It incorporates only as a corporation. An S corporation is an S corporation only in the context of income taxation. An S corporation becomes an S corporation when it files an election with the Internal Revenue Service to be taxed under the provisions of Subchapter S of the Internal Revenue Code. You don’t even have to be a corporation to be taxed as an S corporation.

A limited liability company can also elect to be taxed as an S corporation. A corporation which does not elect to be taxed under subchapter S of the Internal Revenue Code is referred to in income tax discussions as a C corporation because by default it is taxed under subchapter C of the Internal Revenue Code.

In order for a corporation to qualify to file an election to be taxed under Subchapter S, the corporation must not have more than 100 shareholders; each shareholder must be an individual, estate, or a qualified trust; each shareholder must consent to the election; the corporation must only have one class of stock; and the corporation must be domestic.

The defining feature of an S corporation is that the corporation does not pay income taxes, its shareholders do. It was designed to be taxed more like a partnership than a corporation. The income or loss generated by an S corporation passes through to the shareholders, the owners of that corporation. The shareholders of an S corporation report their share of the corporation’s taxable income or loss on their individual income tax returns.

For example, if you own 10% of an S corporation that made $100,000 this year, you would report an additional $10,000 of income on your individual income tax return and personally pay the increase in income taxes that resulted from this additional $10,000 of income. This is where many people get confused about S corporation income taxation. If the S corporation is profitable the shareholder will generally pay additional income taxes on his or her pro rata share of the corporation’s taxable income. It is not dependent on whether the corporation distributes money to the shareholder. If the corporation keeps all the money it made, the shareholder would have to find another source of money to pay the resulting increase in their income tax. However, distributions from S corporations are generally tax-free (unless these distributions exceed the shareholder’s basis in their stock, which is a topic for another day.).

Using the same example, if the corporation was a C corporation, the corporation would pay the income tax on its $100,000 of taxable income, not its shareholders. However, any distributions made from the corporation to its shareholders would generally be taxable to the individual shareholders as a dividend.

It would seem the simplest option would to be taxed as a C corporation. So what’s the point of electing to be taxed as an S Corporation? Remember, as with any income tax option, decisions are seldom simple and always depend on a taxpayer’s particular circumstances. There are many factors to consider in the decision to whether or not to be taxed as an S corporation. But as a general rule, perhaps the most direct benefit of electing to be taxed as an S Corporation is the avoidance of the double taxation that can and most likely will result from owning corporation taxed as a C corporation.

A C corporation, when it makes money, pays income tax on that. If any of the money remaining after the corporate level income taxes are paid is distributed to its shareholders, then the shareholders will have to pay income tax again on the portion of the this money received from the corporation as taxable dividends.

For the closely held business, the smaller corporation, the extent of this double taxation may not be felt until the owners are ready to retire. Many small companies use their profits to grow their business. These profits are retained in the business and reinvested in assets such as inventory, equipment, and land and buildings. When these owners are ready to quit their business and they are ready to sell their assets, if they have operated successfully for many years as a C corporation, they often feel the pain of double taxation. When they sell their assets it’s often at great gain. And if the gain is large enough, 40% of this gain could be paid in federal and state income taxes at the corporate level. When the remaining money is distributed to them as shareholders, it is taxed again at the individual level.

The advantage of electing to be taxed as an S corporation is the avoidance of this double taxation. Over the life of a business the tax savings as a result of avoiding double taxation by electing to be taxed as an S corporation could be substantial.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]