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Corporations are always taxed as “C” corporations
unless an election is made to be treated as an “S” corporation.
C corps are preferred by large corporations (more than 75 shareholders),
when a buildup of paid in capital is needed, when the Company expects
to receive dividends from its holdings and by companies expecting
to conduct public offerings.
C corps are preferred when the net worth of the company is an
important consideration. Construction companies and companies that
require bonding often run into this consideration. C corps also
provide some employee benefit advantages such as the adoption of
Section 125/Flexible benefit plans. Under certain situations, up
to 70% of the income from dividends can be excluded.
C corporations do not have to pay taxes on many employee benefits.
These include such typical benefits as life insurance under section
105, medical reimbursement plans under Section 125, and Section
139 parking plans. Sole proprietors, partners and 2% owners of
S corporations must face tax recognition.
The main disadvantage to the C corp is the possibility of double
taxation. Unlike a sole proprietorship, S corp, LLC or partnership,
the C corp must pay its tax at the corporate level and may not “pass
through” the gains or losses to the owners. Then, if a distribution
is made to the owners, the owners must recognize this distribution
as income and again pay a tax.
With competent accounting and tax advice, the chance of double
taxation can be reduced. Many companies simply close their books
a little before the fiscal year end and pay bonuses or pre-pay
qualified expenses to reduce the tax burden. In some cases, such
as a windfall or a sale of the business, this is not possible.
In addition, it must be done on a year by year basis.
An S election is made on IRS Form 2553. S corps are typically
used by small business. Examples include consultants, many retail
businesses, sales driven organizations,
many closely held and family businesses, and companies that maintain
significant depreciation schedules. Companies that expect losses
for the first few years often choose S status initially, even if
they plan to convert later.
S Corp rules provide that no more than 25% of the corporation's
income can come from passive activities. Since this includes rents
(as well as annuities, dividends, royalties, etc.) C corps are
often preferred for companies receiving significant dividends from
stockholdings in other companies. LLCs are often preferred for
real estate syndications, equipment leasing, investment holding
companies, and businesses that will derive their principal income
from passive investments.
Not every corporation will qualify as an S corp. It is possible
(easy in fact) to take an S corp election and then get rid of it.
The reverse is not true. If a C corp converts to an S corp or LLC,
then any remaining losses become trapped and cannot be taken unless
the entity converts back to a C at some point.
The S Corp Requirements as of 2003 are:
1. It is a domestic corporation. This means that it is incorporated
in the United States.
2. It has no more than 75 shareholders. A husband and wife (and their
estates) are treated as one.
3. Its only shareholders are individuals, estates, Qualified Subchapter
S corporations, exempt organizations described in section 401(a) or 501(c)(3),
or certain trusts.
4. It has no nonresident alien shareholders.
5. It has only one class of stock. (This rule applies whether the other
class has issued any shares or not.)
6. It is not one of the following ineligible corporations:
a. A bank or thrift institution that uses the reserve
b. An insurance company
c. A corporation that has elected to be treated as a possessions corporation
under section 936
d. A domestic international sales corporation (DISC)
7. It has a permitted tax year. (This will be a calendar year as its
fiscal year unless there is a business purpose satisfactory to the IRS
that another fiscal year must be used.)
8. Each shareholder consents to S corporation treatment.
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