To gain the protection of limited liability, many businesses incorporate. However, this subjects the profits to two layers of taxation: the corporate tax on company earnings and the personal income tax on distributions. To take advantage of the more favorable pass-through tax treatment, corporations that meet certain requirements can elect to become an S corporation.
To make an S corp election, the company must meet a number of restrictions regarding its ownership, business activities, and shares. An S corp can't have more than 100 shareholders. The shareholders can only be U.S. citizens, U.S. residents, estates and certain trusts. Finally, the S corp generally can't have more than 25 percent of its income generated by passive activities, such as investments. If it does, it owes an extra tax on those profits. If this occurs three years in a row, the S corp loses its status.
Effects of the Election
By making the S corp election, the corporation becomes a pass-through entity. Instead of the corporation paying the corporate income tax and then paying taxable dividends to the shareholders, in an S corp, the shareholders report the income or losses directly on their personal income tax returns. Doing this allows shareholders to avoid double taxation on the gains of the corporation and, if the business has a bad year, to take the losses on their own tax returns.
The corporation must file Form 2553 to make the S corp election; it must specify the date on which the election becomes effective. It must also specify the accounting period it will use for the S corp's tax year. Each subsequent year, the S corp must fill an informational return using Form 1120-S and give each shareholder a Schedule K-1. The Schedule K-1 documents the type and amount of income and losses the shareholders must include on their personal returns.
Ending the S Corp
If the S corp violates any of the requirements, the S corp election is nullified and the company changes back to a C corp. In addition, if a majority of the shareholders agree, the S corp can voluntarily revert back to a C corporation. When this occurs, the shareholders no longer get to include the income or losses directly on their income tax return. Instead, the company must pay the corporate income tax and then make taxable distributions to the shareholders at its discretion.