C corporations are required to pay federal taxes and file annual corporate tax returns using Form 1120. Current federal tax rates range from 15 to 39 percent of taxable income; any remaining after-tax corporate profits can be kept by the corporation as retained earnings or paid out to shareholders as dividends. In the case of dividend payouts, corporate shareholders are required to pay individual taxes on such income. In this way, C corporations are subjected to double taxation—profits are taxed once at the corporate level and a second time at the individual level, after distribution as dividends.
An S corporation is another form of corporation; it has the same basic organizational structure as a C corporation. The Internal Revenue Code sets out certain requirements for S corporation status: (1) corporation must have 100 or fewer shareholders; (2) shareholders can only be individuals, estates or certain trusts; (3) nonresident aliens cannot be shareholders; (4) there can only be one class of stock; and (5) the election to be treated as an S corporation must be made by filing Form 2553 with the Internal Revenue Service within two-and-one-half months of the date of incorporation.
Advantages of S Corporations
One of the major advantages of an S corporation over a C corporation is that S corporations are generally not subject to double taxation. An S corporation does not pay corporate income taxes, except for certain capital gains and passive income taxes. Instead, the profits of an S corporation pass through to its shareholders and are taxed as individual income. Another major advantage of an S corporation over a C corporation is that business losses are also passed through to shareholders and therefore, can be deducted from individual income—which is not the case with C corporations.
The election of S corporation status only applies to federal taxes not state taxes. In fact, the states of California and Illinois tax S corporation profits, albeit at lower rates than C corporations; and the District of Columbia does not recognize S corporation status at all.
S Corporation, LLC or Partnership?
S corporations are generally a good choice for small businesses that want to use the corporate form and avoid the double taxation problem of C corporations. It should be noted, however, that there are other company forms, such as partnerships and limited liability companies, that offer the same “pass through” tax benefits of S corporations without having to incur the significant cost of maintenance (paperwork and formalities) associated with an S corporation. So persons considering an S corporation should investigate a partnership or LLC before making a final decision.