S corporations are corporations that elect to pass in-come, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate in-come. S corporations are responsible for tax on certain built-in gains and passive income.
To qualify for S corporation status, the corporation must meet the following requirements.
It must be a domestic corporation.
It must have only allowable shareholders.
Allowable shareholders include individuals, certain trusts, and estates.
Unallowable shareholders include partnerships, other corporations, and non-resident aliens.
It must have no more than 100 shareholders.
It must have only one class of stock.
It may not be an ineligible corporation, such as cer-tain financial institutions, insurance companies, and domestic international sales corporations.
In order to become an S corporation, the corporation must submit Form 2553, Election by a Small Business Corporation, signed by all the shareholders.
Some or all of the benefits of establishing a corporation are lost when corporate formalities are not strictly fol-lowed. When a corporation is formed, a separate entity is created, with legal rights and responsibilities that are distinct and separate from the shareholders.
Corporations are often formed for purposes of protect-ing shareholders from liability. However, if formalities are not followed, the corporation is not adequately capi-talized, or personal and corporation funds are intermin-gled, the corporate veil can be easily “pierced” by a court, which results in personal liability for the shareholders.
Since a corporation is a separate legal entity, sharehold-ers performing services for the corporation are treated as employees and must be paid reasonable wages for the duties performed. Even with a single-sharehold-er corporation, federal and state payroll taxes must be withheld and a year-end W-2 must be submitted, just as with any other employee.
If tax formalities are not followed, such as reason-able wages being paid to shareholders, the IRS can re-classify income and expenses, causing unwanted tax consequences.
S Corporation Forms
Annual Return of Income—Form 1120S, U.S. Income Tax Return for an S Corporation
A corporation or other entity must file Form 1120S if:
It elected to be an S corporation by filing Form 2553,
The IRS accepted the election, and
The election remains in effect.
An S corporation may need to make estimated tax pay-ments if it expects to owe taxes on certain built-in gains or passive income. Corporations must use electronic funds transfers to make all federal tax deposits, includ-ing installment payments of estimated tax.
Social Security and Medicare taxes and income tax withholding—Form 941, Employer’s Quarterly Federal Tax Return. Generally, each quarter, all employers who pay wages subject to income tax withholding or So-cial Security and Medicare taxes must file Form 941 by the last day of the month that follows the end of the quarter.
Federal unemployment tax (FUTA)—Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Generally, the FUTA tax applies to the first $7,000 paid to each employee during a calendar year after subtracting any payments exempt from FUTA tax.
Depositing employment taxes. Employers must depos-it federal income tax withheld, plus both the employer and employee portion of Social Security and Medicare taxes, plus or minus any prior period adjustments to tax liability. All taxpayers must use the Electronic Fed-eral Tax Payment System (EFTPS) to make federal tax deposits.
State payroll tax requirements. The corporation should check with each state in which it conducts business or has employees to ensure the state requirements are met.
Income Tax—Form 1040, U.S. Individual Income Tax Return, and Schedule E, Supplemental Income and Loss
Schedule E is used by the shareholder to report income or loss from the S corporation as provided to the share-holder on Schedule K-1. Losses from S corporations are limited to the shareholder’s basis. Other separately stated items from Schedule K-1 are reported on various forms and schedules of the shareholder’s Form 1040.
Unreimbursed business expenses paid by an S corpora-tion shareholder are deductible as employee business expenses, subject to the 2% AGI limitation, only if the corporation has a resolution or policy requiring pay-ment of the expense.
Estimated Tax—Form 1040ES, Estimated Tax for Individuals
Estimated tax is the method used to pay tax on income that is not subject to withholding, such as S corporation income.
S Corporation Advantages/Disadvantages