Incorporation (S Corp, C Corp)

S Corporation

An S corporation, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.

S corporation status provides many of the benefits of partnership taxation and at the same time gives the owners limited liability protection from creditors. The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379). S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.

Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. S corporations are separate legal entities from their shareholders and, under state laws, generally provide their shareholders with the same liability protection afforded to the shareholders of C corporations. For federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were not previously taxed. Also, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation.

Unlike a C corporation, an S corporation is not eligible for a dividends-received deduction. Furthermore, unlike a C corporation, an S corporation is not subject to the 10% of taxable income limitation applicable to charitable contribution deductions.

Qualification for S Corporation Status

In order to elect to be treated as an S corporation, the following requirements must be met:

  • Must be an eligible entity (a domestic corporation or limited liability company that has elected to be taxed as a corporation).
  • Must have only one class of stock.
  • Must not have more than 100 shareholders. Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
  • Shareholders must be U.S. citizens or residents and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and tax-exempt corporations, notably 501(c)(3) corporations, are permitted to be shareholders.
  • Profits and losses must be allocated to shareholders proportionately to each one’s interest in the business.

If a corporation meets the foregoing requirements and wishes to be taxed under Subchapter S, its shareholders may file IRS Form 2553, “Election by a Small Business Corporation”. Form 2553 must be signed by all of the corporation’s shareholders. If a shareholder resides in a community property state, the shareholder’s spouse generally must also sign the 2553.

The S corporation election must typically be made by the fifteenth day of the third month of the tax year for which the election is intended to be effective, or at any time during the year immediately preceding the tax year. Congress has directed the IRS to show leniency with regard to late S elections. Accordingly, the IRS will often accept a late S election.

Some states such as New York and New Jersey require a separate state-level S election in order for the corporation to be treated, for state tax purposes, as an S corporation.

If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, if as a result of stock transfers, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to a regular C corporation.

Furthermore, if more than 25% of an S corporation’s gross receipts consist of passive income for three consecutive years when the corporation has accumulated earnings and profits, the S corporation will automatically lose its subchapter S status and revert to a regular C corporation.

C Corporation

A C corporation refers to any corporation that, under United States income tax law, is taxed separately from its owners. It is distinguished from an S corporation, which is not taxed separately. Most major companies (and many smaller companies) are treated as C corporations for U.S. income tax purposes.

C Corporation vs. S Corporation

Shareholders of a corporation may elect to treat the corporation as a flow-through entity known as an S corporation. An S corporation is not itself subject to income tax; rather, shareholders of the S corporation are subject to tax on their pro rata shares of income based on their shareholdings. To qualify to make the S corporation election, the corporation’s shares must be held by resident or citizen individuals or certain qualifying trusts. Unlike corporations treated as S corporations, a corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.

Close Corporation

A close corporation is generally a smaller corporation that elects close corporation status and is therefore entitled to operate without the strict formalities normally required in the operation of standard corporations. Many small business owners find this benefit invaluable. In essence, a close corporation is a corporation whose shareholders and directors are entitled to operate much like a partnership. The close corporation election is made at the state level, and state laws vary with respect to the eligibility of close corporation status and the rules governing them. Some states do not authorize them.

Corporations must meet particular requirements to be eligible for close corporation status. Generally speaking, a close corporation cannot have more than a particular number of shareholders—the limit is between 30 and 35 in most states. A close corporation cannot make a public offering of its stock. Typically, shareholders must agree unanimously to close corporation status, and a written shareholders’ agreement governing the affairs of the corporation must be drafted. Shareholders’ agreements are fairly complex and should probably be left to experienced counsel.

Close corporations enjoy relaxed rules with respect to the formalities of governance. For example, close corporation shareholders typically need not hold formal annual meetings. Close corporation shareholders may override the directors and act on their own, thereby usurping an authority typically lodged with the directors.

Professional corporation

Professional corporations are those corporate entities for which many corporation statutes make special provisions to regulate the use of the corporate form by licensed professionals such as attorneys, architects, engineers, public accountants, and doctors. Legal regulations applying to professional corporations typically differ in important ways from those applying to other corporations.

Professional corporations, which may have a single director or multiple directors, do not usually afford that person or persons the same degree of limitation of liability as ordinary business corporations (see LLP). Such corporations must identify themselves as professional corporations by including “PC” or “P.C.” after the firm’s name. Professional corporations often exist as part of a larger, more complicated, legal entity. For example, a law firm or medical practice might be organized as a partnership of several or many professional corporations.

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