In general an S corporation is almost exactly like a regular corporation. It operated in the same manner, must have directors, officers, and shareholders, and the entity functions as a regular corporation. The only difference is that the S corporation elects to be taxed as a partnership for federal tax purposes. Eligible domestic corporations can avoid double taxation because S corporations are exempt from federal income tax, although there may be tax on certain passive income or capital gains. With S corporations the income, losses, tax credits, and other tax items of the business flow through the corporation to the shareholders, as with a partnership. Income is only taxed at the shareholder level and the business avoids double taxation. Like regular corporations, shareholders are protected by limited liability.
S corporations must meet some qualifications. They cannot have more than 100 shareholders. Shareholders must be people who are U.S. residents or citizens, so corporate or partnership shareholders are excluded. There must be only one class of stock, and profits and losses must be allocated to the shareholders according to their percentage of interest in the company. Eligible entities are domestic corporations, partnerships, or single- or multiple-member limited liability companies.
Advantages
Corporations must use the accrual accounting method unless they are a small corporation with receipts of $5 million or less. S corporations don’t have to use the accrual method unless they have inventory and can thus use the cash method of accounting, which is preferable.
Corporate losses can be passed through shareholders. The owner, as a shareholder, may be able to take the loss against income that appears on his or her personal income tax return.
There is the advantage of having corporate limited liability without suffering from double taxation.
S corporations do not accumulate passive income like dividends or interest, because this business entity does not have earnings and profits. This means that S corporations avoid the additional 15 % rate hike for personal holding companies. In terms of federal taxes, personal holding companies are corporations owned by a small number of individuals that received most of its income through passive means like dividends, interest, or rents.
It is easier to raise capital as a corporation, versus as a sole proprietorship or partnership, because of the stock structure.
Disadvantages
There are shareholder requirements for S corporations: all must be U.S. citizens, health and accident insurance may not be deducted by the corporation, and there may only be up to 100 shareholders.
Deductions of pass-through losses are limited to the shareholder’s basis in the S corporation. However, C corporation shareholders cannot deduct any losses unless their stock becomes worthless or is sold at a loss.
It can be costly to set up and follow corporate formalities.
Shareholder-employees must receive reasonable compensation before they can receive any non-wage distributions.
S corporations can only have one class of stock.
If the shareholder-employee owns more than 2% of the corporation, most fringe benefits provided by the corporation are taxable as compensation.
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