S-Corporation Tax Election

Corporations come in two primary forms, C-corporations—named for Subchapter C of the Internal Revenue Code—and S-corporations, named for Subchapter S.

C-corporations are the most standard version of this business entity, while S-corporations are entities that begin as C-corporations, but later elect to be subject to pass-through taxation like a sole proprietorship or partnership.

When a corporation files to be an S-corporation, it is strictly a tax adjustment, not a legal status adjustment. Though the entity will be taxed differently, it retains the same abilities and obligations as a C-corporation.

S-Corporations vs C-Corporations

An S-corporations is a tax concept. You create your corporation under state law. Then, Federal income tax laws permit you to elect to be treated as an S-corporation.

Corporations that choose not to make this election are described for tax purposes as C-corporations. Here’s the difference:

  • - C-corporations must file tax returns and pay tax on corporate taxable income. Items of loss, gain, and credit are all taken into account at the corporate level.
  • - However, S-corporations have no corporate income tax return. Items of income, gain, loss, credit, or deduction are taken into account or passed through at the shareholder level in proportion to a shareholder’s ownership interest.

S-Corporation Eligibility

Not every corporation can become an S-corporation. Certain technical requirements must be met to qualify. These include:

  • The corporation must be formed in the United States;
  • The corporation can have no more than 100 shareholders;
  • All shareholders must be individuals (with certain exceptions for trusts or estates);
  • None of the shareholders can be non-resident aliens;
  • The corporation can issues only one class of stock
  • The corporation cannot be an insurance company or a domestic international sales corporation.

These eligibility standards must exist at the time the S-corporation election is made and exist continuously throughout its corporate existence. If an eligibility standard ceases to exist, the S-corporation status is terminated immediately. If this happens, the corporation would be taxed as a C-corporation with no pass-through of tax attributes to shareholders.

For purposes of applying these eligibility standards, husbands and wives owning shares jointly count as a single shareholder. Joint owners other than husbands and wives are counted separately.

S-Corporations Advantages

S-corporation election is a popular choice for many small businesses when they form a corporation. Many businesses that choose to incorporate decide that S-corporation status is the best choice for the following reasons:

  • Pass-Through Taxation -This refers to the taxing of business income through the owners’ personal income tax returns. In other words, the business entity itself isn’t taxed, but the business earnings are taxed as part of the owner’s individual personal income.This is also one of the fundamental factors that distinguish S-corporations from C-corporations.
  • limited liability companies (LLCs) and sole proprietorships are also subject to pass-through taxation. C-corporations, however, are subject to double taxation, meaning that they are taxed at the corporate level and again at the individual level when dividends are distributed.
  • Note: When business income is taxed via pass-through taxation, the business entity itself is classified by the IRS as a disregarded entity, meaning, an entity that exists but is not directly taxed.
  • Annual Taxation - Unlike C-corporations that must file their taxes quarterly, S-corporations only need to file their taxes annually.
  • The Ability to Attract Investors - S-corporations provide a great deal of investment opportunities due to their ability to be bought and sold in the form of shares, or stock.
  • Perpetual Existence - This refers to the presumption that a corporation has perpetual existence unless its articles of incorporation provide otherwise.

S-Corporation Disadvantages

  • Limited Shareholders - S-corporations can have no more than 100 shareholders.
  • Ownership Restrictions - Partnerships and corporations can’t be shareholders of an S-corporation. In contrast, partnerships, C-corporations, and LLCs don’t have restrictions on who can be a partner, shareholder, or member.
  • Only One Class of Stock - S-corporation can issue only one class of stock. This single-class of stock issue often comes up when shareholders loan money to the corporation.
  • More IRS Scrutiny - Because of the way they distribute dividends and salary, S-corporations generally receive more IRS scrutiny. Filing mistakes can cause your S-corporation status to be terminated automatically.
  • The Expense - S-corporations are generally more expensive to form and maintain than other entity structures.

How to Form an S-Corporation

All corporations begin as C-corporations. So, to form an S-corporation, you must start by forming a C-corporation under state law. Once you have formed a C-corporation you can then file IRS Form 2553 to elect S-corporation status.

In most cases, an LLC will first need to file IRS Form 8832 to elect to be taxed as a C-corporation, and then file IRS Form 2553 to switch to S-corporation status.

In either case, IRS Form 2553 must be signed by all shareholders and must generally be filed within 75 days of the date your corporation was formed.

For more detailed information regarding S-corporation election in Texas, consult with an experienced Texas business law attorney.