The “S” corporation is of considerable interest to the small business owner, because it generally does not pay taxes. Instead, it passes reported earnings through to its shareholders, who report the income on their tax returns. This avoids the double taxation that arises in a “C” corporation, where a company’s income is taxed, and then the dividends it issues to its shareholders are taxed as income to them a second time. The amount of income is allocated to each shareholder on a simple per-share basis. If a shareholder has held stock in the corporation for less than a full year, then the allocation is on a per-share, per-day basis. The per-day part of this calculation assumes that a shareholder still holds the stock through and including the day when the stock is disposed of, while a deceased shareholder will be assumed to retain ownership through and including the day when he or she dies.
An “S” corporation has unique taxation and legal protection aspects that make it an ideal way to structure a business if there are a small number of shareholders. Specifically, it can only be created if there are no more than 75 shareholders, if only one class of stock is issued, and if all shareholders agree to the “S” corporation status. All of its shareholders must be either citizens or residents of the United States. Shareholders are also limited to individuals, estates, and some types of trusts and charities. Conversely, this means that “C” corporations and partnerships cannot be shareholders in an “S” corporation. The requirement for a single class of stock may prevent some organizations from organizing in this manner, for it does not allow for preferential returns or special voting rights by some shareholders.
There are a few cases where an “S” corporation can owe taxes. For example, it can be taxed if it has accumulated earnings and profits from an earlier existence as a “C” corporation and its passive income is more than twenty-five percent of total gross receipts. It can also be liable for taxes on a few types of capital gains, recapture of the old investment tax credit, and LIFO recapture. If any of these taxes apply, then the “S” corporation must make quarterly estimated income tax payments. On the other hand, an “S” corporation is not subject to the alternative minimum tax.
If the management team of an “S” corporation wants to terminate its “S” status, the written consent of more than fifty percent of the shareholders is required, as well as a statement from the corporation to that effect. If the corporation wants to become an “S” corporation at a later date, there is a five-year waiting period from the last time before it can do so again, unless it obtains special permission from the IRS.