Certain small business corporations may elect not to be subject to federal corporation
income tax as permitted in Subchapter S of the Internal Revenue Code. Shareholders of such corporations are not engaged in a trade or business as explained
in RS 01802.015.
Small business corporations that make this election are called S corporations. 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.
Each shareholder of an S corporation must include on his or her individual tax return
his or her pro rata share of the annual corporate income, regardless of whether such
income is distributed or undistributed. The electing corporation, although not liable
for corporate income tax, must file an informational return on IRS Form 1120-S (U.S. Income Tax Return for an S Corporation).
The purpose of this law is to aid and foster small business corporations. Rather than
taxing the S corporation, the individual shareholders are taxed in a manner similar
to the way partnership earnings are taxed. In general, this treatment permits businesses
to select the form of business organization without an additional tax burden.
To qualify for S corporation status, the corporation must:
be a domestic corporation;
have only allowable shareholders (including individuals and certain trusts, and estates,
but not partnerships, corporations, or non-resident aliens);
have no more than 100 shareholders;
not be an ineligible corporation (i.e., certain financial institutions, insurance
companies, and domestic international sales corporations); and
submit IRS Form 2553 (Election by a Small Business Corporation) that is signed by all of the shareholders.
The election to be an S corporation may be revoked if the owners of the shares vote
to do so, or if the corporation no longer meets the requirements for S status. Termination
of the tax election does not terminate the corporate structure. However, the corporation
becomes subject to federal corporate income tax in the same manner and extent as if
the corporation did not make an election.
An election by the shareholders does not change the character of the corporation income.
The corporation still earns income. When the corporation carries on a trade or business,
the individual shareholder will never have net earnings from self-employment from
that trade or business. However, the shareholder may be subject to employment taxes
on reasonable compensation the shareholder receives from the corporation. Sometimes
the shareholders may receive dividend payments on their investments. Dividends paid
on capital investments are not earnings from self-employment.
Questions may arise in connection with claims involving individuals who are shareholders
in this type of corporation relating to the bona fides of the corporate entity and
its operation. In general, the approach set forth above applies in resolving such
questions. An election not to be subject to corporate taxes is not adequate grounds
for questioning the bona fides.