Special Articles

S corporation vs. C corporation

By Peter Jason Riley

Often one of the first critical issues that individuals face when they incorporate their business is whether to be taxed as a "C" or "S" type corporation for federal income tax purposes. Keep in mind that when you initially incorporate your business in a particular state that you are generally registering the business as a legal organization in the state of your incorporation, it is not necessarily a tax matter. While S corporations are corporations for purposes of state law, not all states recognize the "S" corporation for income tax purposes. The "S" corporation is recognized in Massachusetts but not in New Hampshire for instance. Be sure to check on the laws in your state before you make this decision. By default the corporation is generally considered a "C" corporation. If you desire the be taxed as an "S" corporation you must file a form 2553 to inform the IRS that the shareholders desire (elect) this tax treatment.

So what is the key difference? The critical distinction is that an "S" Corporation generally passes its taxable income or loss directly through to the shareholders while a "C" type corporation will pay taxes on the corporate income directly. For example:

Sales $100,000 $100,000
Less - General expenses $50,000 $50,000
Less - Officers Salary $35,000 $35,000
Taxable income $15,000 $15,000
How and where taxable? Directly to shareholders at their applicable tax rate according to their ownership % Directly to the corporation

In our above example the $15K taxable income for the "S" Corporation will be passed through to the shareholders to be taxed directly on their 1040 returns. If the corporation is owned 50% ~ 50% by 2 shareholders each will report $7,500 as income (on schedule E) in the same year as the corporation even though they may not have actually received the income. This income is passed to the shareholder when the "S" Corporation files its 1120S income tax return. The 1120S will include a Form K-1 that will inform the shareholder of his or her pro rata share of taxable income. The shareholder can then receive this taxable income or distribution in cash. The "C" Corporation will simply write a check to the U.S. Treasury for the income taxes due on the $15K. The "C" Corporation is taxed @ 21% so the tax due on $15K will be $3,150.

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Advantages & Disadvantages of the "S" Corporation Status

There are several major federal income tax advantages of operating as an S corporation instead of as a regular C corporation. These advantages include:

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Other "S" Corporation Matters

Not all corporations may elect S status. The election is available only to qualifying "small business corporations." A corporation must formally elect to be taxed as an S corporation by filing Form 2553, "Election by a Small Business Corporation," with the IRS.

An S corporation's taxable income must be computed in order to determine the items of income or loss to pass through to the shareholders. An S corporation's taxable income generally is computed in the same manner as that of a partnership. Thus, items of income, gain, loss, deduction and credit, the separate treatment of which could affect the tax liability of a shareholder, must be passed through separately to each shareholder. The tax character of these items is determined at the corporate level, and they retain their character when passed through to the shareholders.

An S corporation that was once a C corporation may be subject to one or more of three separate taxes (e.g., the "built-in gains" tax). This rule is an exception to the general rule that S corporations are not subject to tax.

Items of income, gain, loss or deduction that pass through to a shareholder are reflected in the basis in his or her stock (and, in some cases, in debt - if any - that the corporation owes to the shareholder) and, where the corporation has earnings and profits, its "accumulated adjustments account." These adjustments are made to prevent income that is taxed to the shareholder (when earned by the corporation) from being taxed again at the shareholder level when later distributed.

Once an S election is made, it applies for all succeeding years unless the election is terminated. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation's ceasing to satisfy the eligibility requirements for S status, or by the corporation's failing a passive investment income test. For example, the election terminates if the S corporation's stock is acquired by a nonqualified shareholder (e.g., a corporation) or if the number of shareholders exceeds the maximum permitted. The election terminates on the day the eligibility requirement is violated.


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