What Does It Mean to Take the S Corp Election for Your Company?

When a new business decides to incorporate, there are some things to decide early in the process. One of the issues companies need to consider is whether or not to file their entity as an S Corporation as opposed to a standard C Corporation.

S Corporation Requirements: Before considering this option, it is important to know whether your company qualifies to make this election. Here are some general guidelines:

  1. The corporation must be domestic.
  2. The amount of company shareholders cannot exceed 100.
  3. Generally, individuals should be the only shareholders; although certain trusts, estates, and other organizations can also own shares in the company.
  4. Shareholders must be U.S. residents.
  5. Certain business types such as financial institutions are not allowed to use this classification.

Why File as an S Corporation: The decision to file as an S Corp will usually come down to the tax implications. The main advantage is that S Corporations are not subject to the standard corporate tax rates.

According to the IRS:

“Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level.”

Profits or losses of an S Corp are passed directly to the shareholders as income, similar to that of a partnership. This means there is no issue with double-taxation because there is no tax liability on corporate income, which could later be taxed again when dividends are distributed to shareholders.

For those considering the S Corporation election, there are some additional considerations. Because the corporate profits pass to the shareholders as income, a shareholder may be taxed on money they did not receive. This could occur if the company elected to retain some of the profits to be used as working capital.

On the plus side, the IRS allows the S Corporation to make additional distributions of profit to shareholders tax-free. It is important to note, however, that this cannot be used as a mechanism to avoid the income tax liability the company officers should incur for the work they did during that tax year. In other words, the IRS expects the S Corp to pay out a reasonable salary to officers that are actively involved in the company’s operations. To avoid trouble in this area, salaries should be determined using comparable wage comparisons with similar industry positions. For additional guidance on the tax implications of S Corporations, consult a professional accountant.

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