Many small businesses regularly use the term “S-Corporation”, but we’ve found that only a handful of people actually understand what this means. In general, when a corporation is formed, it will be treated as a “C-Corporation,” which means that the entity will be treated as a separate taxpaying entity from its shareholders. Therefore, the profit of the corporation is taxed as the corporate level and taxed again when it is distributed to the shareholders via dividend. This results in “double taxation.” For this reason, many small business owners are interested in forming an s-corporation.
Simply stated, a s-corporation is a “small business corporation” that makes an election under section 1362 of the Internal Revenue Code. This election (the “S-election”) will qualify the subject corporation for Subchapter S treatment for federal income tax purposes.
Under IRC Section 1361, a “small business corporation” is defined as an eligible, domestic corporation which does not have:
- More than 100 shareholders;
- As a shareholder a person (other than an estate, a trust described in Section 1361(c)(2), or an organization described in section 1361(c)(6)), who is not an individual;
- A nonresident alien as a shareholder; and
- More than one (1) class of stock
In practical terms, this means that corporations and partnerships can never be a shareholder of an s-corporation, except in very limited circumstances. Also of specific interest, stock owned by a husband and wife is treated as owned by a single shareholder, regardless of the form in which they own the stock (individually or in their estate). Despite California’s treatment of community property interests, the treatment of spouses as a single shareholder for determining the number of shareholders in an s-corporation still applies.
To make an s-election, an eligible entity must complete and file the IRS Form 2553 (i) no more than two months and 15 days after the beginning of the tax year the election is to take effect, or (ii) at any time during the tax year preceding the tax year it is to take effect. Although the IRS does provide limited circumstances when a late s-election may be effective, it is a best practice to follow these guidelines.
If you’re the owner of a small business that has experienced double taxation as a c-corporation, or if you’re considering forming a business entity for the first time, be sure to partner with an experienced business attorney and CPA to plan for your future growth and tax liabilities.