This is the second installment in a series of articles which addresses the tax implications of various business structures. The business structure that an entrepreneur chooses for his or her business has both legal and tax implications.[1] This installment will discuss the implications of an S Corporation.
As discussed in the first installment, C Corporations are legal entities separate from their owner (https://www.sba.gov/starting-business/choose-your-business-structure/corporation [accessed Nov. 4 2016]). The separate legal entity was a distinct advantage for business owners over an unincorporated business. But the disadvantage was that the C Corporation was subject to taxation both at the entity level and the shareholder level (double taxation).
In the 1950’s U.S. Congress decided to review Subchapter C of the Internal Review Code because they felt that C Corporations were too restrictive for small businesses. What resulted from this examination was Subchapter S of the Internal Revenue Code.
The purpose of Subchapter S was to allow small businesses to select a corporate business structure without being concerned about tax implications and to allow the income or losses from their business to be taxed at the shareholder level instead of at the corporate level (S. Rept. No. 1983, 85th Cong., 2d Sess., p. 87 (1958)).
An S Corporation is a “flow-through” entity for tax purposes. Like a partnership, all of the income and losses “flow-through” the S Corporation to the individual shareholders, retaining their character. For example, if the S Corporation sells stock at a long-term capital gain (LTCG), this LTCG flows through to the individual shareholders and retains it character so that it is taxed at LTCG rates to the shareholders.
The S Corporation would seem on first glance to solve the problems of the C Corporation. It is a separate legal entity, but there is only one level of taxation.
But do remember that an S Corporation is a construct of the U.S. Congress.[2] That means that it is an election that the shareholders need to make (with Form 2553-Election by a Small Business Corporation). That also means that most of the other corporate rules governing formation and dissolution, for example, are still governed by the C Corporation rules.
Further, there are several restrictions to the S Corporation which have made them a little more unappealing. Many of these rules have been loosened over the years, but there are still restrictions on the number of shareholders and type of shareholder which can own S Corporation stock.
One restriction concerns the allocation of profits and losses. A shareholder receives a pro rata share of each item of income or loss based upon their stock ownership on each day of the tax year (IRC 1366(a), Treas. Reg. 1-1366-1(a)). Another restriction is that the S Corporation can only have a single class of stock (IRC 1361(b)(1)(D)).
These restrictions mean that the shareholders cannot determine the allocation of income or loss items through an agreement or stock ownership. These rules decrease the flexibility of an S Corporation.
In the next installment, we will look at Limited Liability Companies (LLC) which is a business structure with generally less restrictions than an S Corporation.
If you have any U.S. small business tax questions or need some help with your taxes, feel free to contact CPA WorldTax at taxinfo@cpaworldtaxllc.com or 888-512-4860.
[1] If you have questions on legal implications, please discuss with your attorney.
[1] Be sure to check the tax laws of your individual State. State tax laws may not recognize the S election.