By default, when corporations are formed they become their own tax paying entity, often referred to as a “C-Corp”. If profitable, the C-Corp would incur income tax liability at the corporate level and its shareholders would also incur tax liability when they received dividends. This taxation scheme is often referred to as double taxation. Since its creation, the “S election” for corporations has increasingly become a preferred tax status for many small businesses. This election avoids income tax liability at the corporate level – avoiding double taxation.
The primary benefit of an S-Corp election is that it allows the shareholders to receive profits free of taxation at the corporate level. The profits will only be taxed at the individual level, thereby avoiding the “double tax” that C-Corporation shareholders are subject to. (C-Corporations are taxed at the corporate and individual level).
However, not all Corporations are able to take advantage of the S-Corporation status. A corporation is only eligible for the S-Corporation election if it meets the following list of ownership requirements:
1. The company must have no more than 100 shareholders
(a husband and wife qualify as one shareholder).
2. All shareholders in the company must be individuals and not other corporations or LLCs
(estates, some exempt organizations and certain trusts qualify as shareholders).
3. No shareholders can be non-resident aliens.
4. There can only be one class of stock in the company
(this limitation disregards differences in voting rights).
5. The company making the election cannot be a bank or thrift institution, an insurance company, or a domestic international sales corporation (DISC).
6. Each shareholder must consent to the S-Corporation tax status
(as explained in column K of IRS form 2553).
7. No more than 25% of the company’s gross corporate income may be derived from passive income.