How S corporations avoid double taxation and limit shareholder liability

¶ … corporation is a regular corporation that opts to tax its profits at the personal income tax level. An S corporation must prepare and file an income tax return, but itself pays no tax (if it complies with all of the technical and complex rules of the Federal law). Each shareholder pays taxes on his/her share of S. corporate income on his or her individual tax return. Owner-employees of an S corporation are treated like partners for purposes of employment and benefits.

is set up in the same manner as a regular corporation and then files for IRS approval (and sometimes state approval) after hurdling through several IRS regulations.

S Corporation allows the small business owner to avoid dealing with the double taxation of profits and dividends. Also, shareholders may be able to offset business losses by the corporation against their personal income, subject to certain restrictions.

Advantages of the S Corporation

Creation of the corporate shield that, in the absence of personal guarantees, limits the liability of stockholders to their capital investment in the corporation and the usefulness for estate planning purposes of the corporate form of business organization are frequently cited advantages of forming an S corporation. Other advantages include:

The independent life of the corporation makes possible its continuation, and the relatively undisturbed continued operation of the business regardless of incapacity or death of one or more stockholders.

Fractional ownership shares are easily accommodated in the initial offering of stock.

The purchase, sale, and gifting of stock make it possible to have changes in ownership without disturbing the corporation's ability to conduct business.

The requirement that the corporation's finances and records be separate from the finances and records of stockholders reduces the risk of unrecognized equity liquidations.

With only a few exceptions, under the Subchapter S election for taxation as a partnership the S Corporation pays no income taxes and corporation income or loss is passed through direct to the stockholders.

To the extent the corporate shield is maintained and other investments and savings of the stockholders are not at risk, the personal life of stockholders is simplified.

The annual meetings of stockholders and consultations with legal counsel can provide stimulus for improved communication within the stockholder group (often a family group) and can provide more comprehensive guidance for management.

Depending on the corporation's business record and the policies and practices of prospective lenders, access to credit and the ability to secure needed resources may be improved.

Earnings representing "return on investment" (interest, rental payments, etc.) are not subject to self-employment tax as long as stockholder-employees receive adequate compensation for labor and management of the business.

Disadvantages of the S Corporation

An S corporation may only have up to 75 shareholders (100 shareholders for tax year beginning after 2004).

Corporations, nonresident aliens, and most estates and trusts cannot be S corporation shareholders.

S corporations may not own subsidiaries, which can make expansion difficult.

S corporations can have only one class of stock, which can impair the corporation's ability to raise capital. Non-voting stock is not considered a "separate class" for this purpose, however.

A shareholder's basis in the corporation does not include any of the corporation's debt, even if the shareholder has personally guaranteed it. This has the effect of limiting the amount of losses that can be passed through. It is a disadvantage compared to partnerships and limited liability companies, and is one of the main reasons that those forms are usually used for real estate ventures and other highly-leveraged enterprises.

S corporation shareholder-employees with more than a 2-percent ownership interest are not entitled to most tax-favored fringe benefits that are available to employees or regular corporations.

An S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.

Example cases of an S Corporations

Shareholders in an S corporation Received Salary Subject to Employment Taxes

Two attorneys who formed an S corporation could not characterize the distributions from the corporation as dividends. The Ninth Circuit Court of Appeals held that since the attorneys were the only persons licensed to provide the legal services on behalf of the corporation, they were considered statutory employees and payments to themselves constituted compensation subject to employment taxes.

This case is the most recent in a trend to re-characterize distributions from S corporations as salary subject to withholding and employment taxes, especially when the shareholders provide personal services. Many taxpayers have attempted to avoid payment of these taxes by forming a corporations and treating the distributions to them as dividends instead of compensation.

Using an S corporation to avoid employment taxes still may be useful when the corporation's income is not derived though the personal services of its employees, such as corporations engaged in the sale or lease of goods or equipment, or businesses that involve inventories or large capital investments.

Conclusion

Assessing the attractiveness of S Corporations involves balancing the advantages of superior liability protection for owners and pass-through taxation against the negative implications of the restrictive eligibility rules.