'S Corporation' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
S Corporation refers to the Subchapter S Corporation type of company filing which measures up to certain requirements set by the IRS Internal Revenue Service. This status provides a corporation which possesses a hundred or fewer shareholders all of the advantages of incorporation while also keeping the benefits of only being tax treated like a partnership.
One of the many benefits to this type of incorporation is that it is able to pass all of the company income straight through to the shareholders, thus avoiding the problems of double taxation which are a real issue with shareholders of public companies. There are some particular requirements that must be met to enjoy these advantages. The firm must be domiciled as a domestic corporation. It cannot possess over a hundred shareholders, and it may only count a single class of stock.
Such S Corporations can pass all of their credits, deductions, losses, and any income straight through to the various shareholders. They may then report this loss or income directly via their own personal tax returns. It allows them to pay out their taxes at generally considerably lower individual income tax rates. There are some built in gains on which the S Corporation will pay the taxes at the corporate level, but these are few and far between.
These S Corporations have to be domestically headquartered firms whose shareholders are estates, certain kinds of trusts, and individuals. A corporation, partnership, or non-resident alien can never qualify for this category of shareholder. There are also some financial institutions, domestic international sales firms, and insurance outfits that are not allowed to incorporate as an S Corporation.
There are some significant advantages to establishing an S Corporation. It builds up real creditability with employees, possible customers, investors, and suppliers as it proves the owner is seriously committed to the firm. Employees may also be shareholders in the company, which allows them to enjoy company salaries while also receiving any corporate dividends and distributions which are tax-free as compared to the investment in the company. This is certainly beneficial for morale.
Paying out distributions in the form of dividends or salaries allows the owners to lower the self-employment tax liability at the same time as it creates wage and expense deductions for the firm. Since this S Corporation will not pay any federal taxes at company level, such losses can be utilized to offset other forms of income for the tax returns of the shareholders. It is always helpful to save money on the onerous American corporate income taxes, particularly for new firms. It is another benefit to these companies that the various interests within the corporation can be easily transferred without creating tax liability events and consequences. Complicated accounting rules do not create restrictions nor does the company have to adjust the basis of property either.
Yet there are also a few downsides to establishing a company as an S Corporation. The IRS closely examines any and all distribution payments made to shareholders in the forms of either dividends or salaries to make sure that they are really employees working in the firm. If wages become characterized as dividends, then the company will lose its compensation paid deduction. Should dividends be characterized as wages, then the company will pay a greater amount of employment taxes. It is also easy for mistakes to be made in the areas of notification, consent, election, filing requirements, or stock ownership requirements that lead to the S Corporation being untimely terminated. There is considerable money and time investment in such a corporate structuring as well.
The owner will have to begin by filling in and filing articles of incorporation to the Secretary of State, get a registered agent on board for the company, and pay any relevant fees and costs involved. Owners often have to pay yearly reporting fees and franchise taxes along with ongoing types of fees. These may be inexpensive, but they can still be deducted under the cost of doing business category. Even if the investors possess non-voting shares of stock in this form of corporate structuring, they will still get distribution and dividend rights.