An incorporated business is automatically designated by the Internal Revenue Service as a C corporation for income tax purposes. However, certain smaller corporations can elect to be taxed as S corporations without forfeiting the liability protections that the corporate structure affords to shareholders. Making the initial election requires filing an IRS form. Once S corporation status is granted, the tax forms the corporation must file annually will change.
S Corporation Taxation
The benefit of electing to be treated as a federal S corporation is that the business is taxed much like a partnership rather than a C corporation. In a traditional corporation, the business is treated as a separate taxpayer apart from its shareholders, and the company is taxed on its business earnings. This leads to the widely publicized complaint of “double taxation” because the corporation pays taxes on its income, and then shareholders pay taxes on the remaining profits when the money is distributed as dividends. With a partnership, the income, deductions, credits and losses of the business “pass through” and are allocated among the partners. The profit or loss is reported on shareholders’ personal returns, eliminating double taxation.
IRS Form 2553
Before a corporation can take advantage of S corporation taxation, Form 2553 must be filed with the IRS. Numerous restrictions apply to the types of corporations that are eligible to make this election. For instance, the corporation may have no more than 100 shareholders; each shareholder must be an individual, estate or trust; and the corporation can issue only one class of stock, none of which can be held by nonresident aliens. All shareholders must consent to the election and sign Form 2553. If Form 2553 is filed within the first two months and 15 days of the corporation’s tax year, the election is effective for the entire tax year; otherwise, the corporation will continue to be taxed as a C corporation until the following tax year.
IRS Form 1120S
Electing to be treated as an S corporation will require the corporation to file its annual tax return on Form 1120S instead of Form 1120. The 1120S is an informational return, and the corporation only pays tax on certain types of income, such as passive income and built-in gains. The form calculates the company’s total ordinary business income or loss, but it’s then allocated among the shareholders for reporting on their personal income tax returns. Just like Form 1120, the 1120S is due on the 15th day of the third month after the close of the tax year.
So that shareholders in an S corporation know how much to report on their personal tax returns, the IRS requires a Schedule K-1 to be prepared for each shareholder and attached to the 1120S. A copy of the K-1 is sent to each shareholder, showing the amount of taxable income that must be reported on the individual’s personal tax return. The K-1 form also reports the character of each tax item. For example, if the S corporation’s total income is comprised of bank interest, capital gains and dividends, the K-1 will report the shareholder’s allocation in each income category.