C-Corporations 101

S Corporation

S Corporation is a type of legal entity that divides its income and loss among shareholders, who are liable to file their own tax returns. This also means that S Corporations are exempt from double taxation because they do not pay any federal tax. In fact, it is the most popular type of business formation among small business owners.

The Internal Revenue Service has defined the nature of such a business in subchapter S of Chapter 1 of IRS Code. The basic concept behind the formation of S Corporation is the idea of single taxation where every shareholder is responsible for reporting income or loss and pay tax according to the individual tax rate.

Major qualification requirements for S Corporations are listed below:

Qualifications

1. The business must be classified as a domestic company.

2. S Corporation can only have one class of stock. The stock must provide identical rights to each shareholder. Amid certain conditions, some states have allowed S Corporations to issue additional class of stocks.

3. There cannot be more than 100 shareholders of the company. On exceeding 100 shareholders, the status will cease to exist and automatically converted to appropriate category e.g. C Corporation. A spouse or a family descending from same individual will only be classified as a single shareholder. Likewise, ex-spouse or relations that have common ancestor is also counted only once. Only if someone prefers to be classified separately then that person can do so.

4. All shareholders must be citizens or legal residents of the United States. Moreover, corporate shareholders are mostly excluded except text-exempt entities such as 501(c) non-profit organizations.

5. For tax purposes, profit and loss must be distributed equally according to the number of shares of each shareholder.

Advantage of S Corporations

(a) The single most attractive characteristic of S Corporation is single taxation. Gains from business operations are not taxed twice. Instead, the owner of a company is only liable to be taxed on individual profits.

(b) Another distinguishing feature is the ability of owners to write off the loss due to start up operations. It is not uncommon for small businesses to incur expenses after forming a new company. The S Corporation status offers small businesses an opportunity to waive tax on most types of expense.

(c) The law provides S Corporations protection from certain liabilities.

Cons of S Corporations

(a) Perhaps the biggest drawback of forming such an entity is limited potential for outside investment. Few investors like to invest in S Corporations due to restrictions such as limited number of shareholders and the ability to issue only one class of stock.

(b) Some small business owners find it inconvenient to hold regular meetings of shareholders. Remember, S Corporation is a legal entity that is required to maintain company minutes of all shareholders.

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