When you file Articles of Incorporation at the state level you can select "S Corporation" status with the IRS. Once the IRS approves the S status, the corporation will be taxed like a partnership or sole proprietorship rather than as a separate entity. What this means is that income is passed through the S corporation to you, a shareholder.
A regular for-profit corporation is required to pay income tax on taxable income generated by the corporation. Additionally, dividends distributed to shareholders may be taxed as income to the shareholders. "Double taxation" is when the corporation and shareholder are taxed. By forming an S corporation, you can avoid the double tax and funnel the corporation’s profits and losses directly to yourself.
Setting up an S corporation can provide you with many benefits including:
- As an owner of an S corporation you can limit your liability.
- S corporate losses pass down to your individual return. You can take the corporation’s loss and use it to reduce your personal income tax.
- S corporations don’t pay income taxes.
- S corporations don’t have to pay FICA (Medicare or Social Security) taxes on profits and dividends.
While S corporations are a great way to limit your taxes, they are not for everyone. If you plan on reinvesting corporate income, an S corporation would not be a good choice.
In order to create an S corporation, you must meet all of the following federal requirements:
- Corporation filed at the state level
- No more than 75 shareholders
- Each shareholder must be a
citizen or a permanent resident alien U.S.
- The corporation issues only one class of stock
- No more than 25% of the corporation’s income is derived from passive investment activities
If you are a calendar year corporation with your fiscal year ending on a date other than December 31, you must get IRS permission before applying for S status.
If more than 25% of the corporation’s income comes from passive sources for three consecutive years, then the IRS will revoke your corporation’s S status. The most common form of passive investment is real estate.
An attorney familiar with tax laws and regulations can help you determine if an S corporation is right for you. An experienced business lawyer can assist you with following the detailed procedural rules needed and adhering to the deadlines for organizing an S corporation.