"C" Corporation vs. "S" Corporation

Corporations are taxed as separate entities from their stockholders. The corporation is taxed on its income and then individual stockholders are taxed on the income that is distributed through dividends. Many small corporations elect to become Subchapter "S" corporations.

Subchapter "S" corporations are defined by the Internal Revenue service as follows:

S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income. (www.irs.gov)

To qualify for S corporation status, the corporation must meet the following requirements:

·     Be a domestic corporation

·     Have only allowable shareholders

o  including individuals, certain trust, and estates and

o  may not include partnerships, corporations or non-resident alien shareholders

·     Have no more than 100 shareholders

·     Have one class of stock

·     Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.

In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders.

Corporate rates can be lower than personal so a "C" corporation may pay slightly less taxes. If profits are left in the corporation and not distributed this form of corporation may result in lower taxes until the stockholders try to take money out of the corporation.  Many owners of closely held corporations will try to take money out of the corporation in the form of salary or bonuses. There are IRS rules regarding unreasonable compensation that aim to prevent this practice. 

I am aware of a grocery store that was set up as a "C" corporation.  The company owned the real estate, the store and the land on which it was located. When the owner and sole stockholder retired he left the company to his children who continued to operate the store. Fifty years after the company purchase the real estate competition from large chain stores made operating a small grocery store unprofitable. The value in the company was in the real estate which was to be sold to a developer in the height of the development market. There was over a million dollars in capital gains.

Because the company owned the real estate it had to pay taxes on the income at capital gains rate. Then to distribute the profit to the individuals they had to pay taxes at rates as if the income was ordinary income. This resulted in double taxation.

Had this company been set up as a "S" corporation the profit from the store could have been passed on to the individuals and avoided double taxation.  For more info on "S" Corporations visit http://www.irs.gov/businesses/small/article/0,,id=203099,00.html

There can also be problems with an "S" selection. If the company makes a profit and choose to reinvest the profits in the company the income tax liability on the taxes still passes to the stockholders even though they see no cash.  

Most small businesses that I am familiar with have chosen to be "S" corporations. If that is your selection you need to file a "S" Corporation election which you can find here. http://www.irs.gov/pub/irs-pdf/f2553.pdf  Discuss your options with your accountant and attorney and chose the structure that fits your needs.