Everything You Need to Know About Tax for S Corps

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Starting a business with the goal of “taking it public” or attracting institutional investors is the goal of many entrepreneurs.

Bootstrapping a business and trying to grow it as large as possible, with the goal of either staying on as the founder/CEO or eventually selling to another business, is another common goal of entrepreneurs.

A third objective for starting a business is aiming to sustain a particular level of income with as few employees as possible. These entrepreneurs don’t have the ambition to grow as big as possible and eventually sell. Their goal is to build a business to a specific income level that can sustain the founder’s preferred lifestyle. This is where the term “lifestyle business” comes from.

For many of these so-called lifestyle businesses, the S corporation entity is a perfect choice for a business entity. You may already be asking yourself how are S corporations both similar and different to C Corporation? What makes an S corporation a good fit for a lifestyle business?

 Both C corporations and S corporations are born the same way – by filing Articles of Incorporation with the state in which the business will be located. (A business organized as a limited liability company can also elect to be treated as an S corporation for tax purposes.)

Once a business has incorporated, it can choose to be taxed either as a C corporation or S corporation.

If the business wants to be taxed as a C corporation, nothing further needs to be done. The default tax entity for an incorporated business is the C corporation.

If the business wants to be taxed as an S corporation, Form 2553 (“Election by a Small Business Corporation”) needs to be filled out and submitted to the IRS. Filling out Form 2553 and submitting it to the IRS is also referred to as “making an S-election.”

As with any other IRS form, there is a deadline to submit Form 2553. The general deadline to submit an S-election is the due date for the S corporation’s tax return. For an S corporation with a December 31 year-end, the deadline to submit both the tax return and S-election is March 15th.

For estimated tax purposes, your tax year is divided into four payments periods:

• 1st Payment Deadline – April 15th – Covers income earned from January 1 to March 31
• 2nd Payment Deadline – June 15th – Covers income earned from April 1 to May 31
• 3rd Payment Deadline – September 15th – Covers income earned from June 1 to August 31
• 4th Payment Deadline – January 15th – Covers income earned from September 1 to December 31

NOTE: If the payment deadline falls on a weekend or legal holiday (i.e. Martin Luther King, Jr. Day in January and Washington D.C.’s Emancipation Day in April), you may wait until the following business day to mail or submit your payment.

If you wanted to start a business in the first half of the 20th century, you had two options:

1. Form a C corporation to take advantage of liability protection but be subjected to two layers of federal tax at the corporate and individual level, or…
2. Choose to be a sole proprietorship or partnership, enjoy the benefit of a single layer of taxation, but forgo the liability protection afforded C corporations.

Neither of these choices was favorable for small and family-owned businesses. In 1946, the Department of Treasury suggested the third choice of entity, one that combined the liability protection of a C corporation with the single layer of taxation from sole proprietorships or partnerships.

U.S. taxpayers waited another 12 years before this suggestion of a hybrid entity actually came to fruition. In 1958, Congress and President Dwight Eisenhower created Subchapter S of the tax code. Subchapter S provided the benefit of limited liability that C corporations have while maintaining the tax benefits of sole proprietorships and partnerships.

 The S corporation was created to address the specific problems faced by small businesses looking to enter markets dominated and controlled by large corporations.
There were four trade-offs, however, to using the new S corporation entity structure:

• Must be a domestic business
• Have a limitation on the number of shareholders it is allowed to have
• Have limitations on who could be a shareholder
• Can only have one class of stock

For many small businesses in the mid-20th century, these limitations were often never an issue.Former Internal Revenue Service commissioner Don Alexander described the S corporation as “a simple structure for simple people” and simple businesses during Congressional testimony in 2006.Let’s take a closer look at each one of these limitations and how they affect businesses 60 years after the S corporation was written into law.  

President Dwight Eisenhower and Congress were successful in creating a hybrid entity that helped small business owners in the U.S.

With most featuring three or fewer shareholders, very few S corporations have to worry about the hurdles surrounding who can be a shareholder, the number of shareholders, being based in the U.S., and having only one class of stock.

That’s why the S corporation is a perfect fit for these lifestyle businesses whose owner has no grand ambition to grow the business as large as possible and attract as many investors as possible.

When grappling with how to best help small businesses in the United States, the Internal Revenue Service, Congress, and President Eisenhower recognized the need for a business entity that combined the limited liability of a C corporation and the simplicity of a sole proprietorship or partnership.

Our esteemed politicians also understood that a new, hybrid business entity could lead to all kinds of unintended consequences. (That’s how the U.S. tax code works, right? Congress passes a law, then CPAs and attorneys figure out different ways of legally working around the new law.)

To make sure that this new, hybrid entity would benefit only U.S. small businesses, the first limitation of an S corporation is that it must be a domestic business.

When S corporations were first created in 1958, the maximum number of shareholders allowed was 10. The number of allowable shareholders slowly increased every few years. The American Jobs Creation Act of 2004 expanded the allowable number of shareholders to its current level of 100.

One of the reasons the number of allowable shareholders kept increasing was to accommodate family businesses that grew over multiple generations to include multiple family members. This problem was also addressed in 2004 when new rules allowed all members of a family (as defined by the tax code) to be treated as a single shareholder.

The S corporation is the only business entity where you can lose your entity tax status.

And it’s pretty simple to do it.

All a business has to do to lose its S corporation status is violate one of the four restrictions mentioned earlier in this article:

1. Have more than 100 shareholders;
2. Having the business be a foreign business;
3. Have an ineligible person or entity as a shareholder; and
4. Have more than one class of stock.

Shareholders must be vigilant in a business’s compliance with these limitations because these limitations can sometimes be inadvertently violated.

If you’re starting a business with the goal of raising capital or attracting investors at some point in the future, electing to be an S corporation could possibly hinder these efforts.

What happens if you have an angel investor from England who wants to provide your business with several hundred thousand dollars? What about a venture capital firm headquartered in Singapore wanting to invest in your business? You would have to turn down both these potential investors because the angel investor is a foreign alien, while the venture capital firm is a partnership. Both foreign aliens and partnerships are ineligible to be S corporation shareholders.

If you are fortunate enough to find angel investors who live in the U.S., many companies will require a number of different investors. The 100 shareholder limitation can fill up pretty quickly.

An S corporation files its tax return on Form 1120-S. Each shareholder receives a Form K-1 from the S corporation. K-1s report each shareholder’s allocation of income, losses, and other financial information from the business. The shareholder includes Form K-1 information on their individual tax return.

This section discusses filing an S corporation tax return and the associated Form K-1s. If you have an S corporation, please contact our office with any questions about how to file a Form 1120-S or how to include a Form K-1 on your individual tax return.