In a recent article published by Forbes, tax attorney Robert Wood discussed some of the reasons why business owners elect to form an S corporation rather than a traditional C corporation.
As Wood explained, a company's Articles of Incorporation are its "birth certificate," but they do not specify C or S status, as this distinction is solely related to tax treatment. All newly incorporated companies are automatically classified under subchapter C of the tax code unless they file an "S election" form with the IRS.
Both types of corporations entitle their owners to limited liability, which Wood notes is "traditionally the reason businesses incorporate." However, income generated by C corporations is effectively taxed twice—first at the corporate level and again when the money is distributed to shareholders. The central advantage of filing for S status is that it eliminates the first layer of taxation. S corporations' income is only taxed at the time it is distributed to shareholders.
On the other hand, there are advantages associated with forming C corporations, which are subject to less stringent accounting standards and fewer formal restrictions regarding who can own shares and how different classes of stock are structured. However, Wood asserts that these advantages are more important for large companies and tax considerations typically make S corporations the favored designation for small businesses.
Determining whether your company is eligible for S status
To qualify for designation as an S corporation, a business must meet a number of different requirements. The organization must have a maximum of 100 shareholders. Generally speaking, those with ownership stakes must be individuals who are either U.S. citizens or resident aliens, although certain trusts and estates are allowed. Partnerships, corporations and non-resident aliens are not allowed to own stock in a corporation seeking S status. Additionally, if the company has issued more than one class of stock, voting rights is the only area in which differences are allowed.
Certain financial institutions, insurance companies and domestic international sales corporations are prohibited from filing for S status. Foreign companies are also not eligible to be treated as S corporations.
Filing for S election for an established C corporation may create tax liabilities
If an existing C corporation is converted to an S corporation, it can be responsible for paying taxes on previous income. However, companies that file for S status within 75 days of incorporating are exempt from this rule.
As Wood wrote, business owners interested in becoming incorporated should consult with an attorney or accountant who has experience handling these issues to determine which type of entity will best meet their needs. However, when it comes time to file the necessary documents and incorporate, organizations should contact a firm that specializes in incorporation.
A full-service company can also provide help with other aspects of business formation and growth beyond the initial incorporation filing, such as registering the corporation to do business in other states.