What Is An S Corporation?
The corporation is by far the most popular form of business entity in the world. There are different types in different countries. In this article, we answer the question of what is an S corporation?
To understand the nature of an S corporation, we first have to discuss a problem with the traditional corporation. Although companies like Google, Microsoft and IBM are described as corporations, they are not. They are actually “C” corporations. The “C” refers to a part of the tax code that defines how these entities will be taxed. While C corporations are the universal choice for publicly traded entities for reasons beyond the scope of this article, they have a major negative when used by smaller businesses.
What is the problem? You probably have heard of it. The C corporations suffer from a double taxation problem. Let's say you have a corporation and bring in $200,000 in profit. This is going to be taxed by the federal government and then by the state. The remaining money then will either be held by the corporation to pay for future expenses and such or distributed to you in the form of a dividend or bonus if you are an employee. Regardless of how the money comes to you, you will be required to then pay taxes on it on your personal tax return. This is the double taxation problem at a go.
So, how can you avoid this problem? Well, the S corporation is the answer to the problem for smaller business ownership groups. The entity works by passing the finances through to the shareholders. This is done much like happens with a partnership, which issues a K-1. It is something that should always be done with an CPA. Regardless, the finances are passed through and taxed only one time at the level of the personal taxes of the shareholders. This resolves the double taxation issue.
There are some catches with this approach. Perhaps the biggest has to do with the shareholder restrictions. The entity is meant to give small businesses tax relief, so the restrictions are designed to limit who can use it. Shareholders must be limited to 100 or fewer in number. The shareholders are usually restricted to individual people, estates and some trusts. Owners usually must be US citizens or resident aliens only. The entity must have only one class of stock and so on. This is an area that should usually be covered in a discussion with an attorney.
What is an S corporation? It is a very popular variation of the traditional corporation that is often used by smaller businesses.