S-corporation - Making The Election
Once you decide to form a corporation for your business entity, you will quickly be faced with another question. Should the corporation pay taxes as a “C” or “S” corporation?
There is a lot of confusion when it comes to the tax designation of a corporate entity. The first thing to understand is a corporation is a “C” designation by default. As a “C” entity, the corporation will file and pay its own taxes with profits and salaries being paid out to employees and shareholders. Since the employees and shareholders have to pay personal taxes on the distributions, “C” corporations are considered double taxation entities. This is generally viewed as a negative thing.
An “S” corporation is the government’s answer to the double taxation issue. The entity essentially acts as a pass through tax structure. The “S” corporation files a tax return with the IRS, but it is only an information tax return. This means no tax is paid. Instead, the finances of the company are passed through to the personal tax returns of the shareholders. The shareholders then report and pay tax to the IRS accordingly.
To gain “S” corporation status, you must take affirmative steps with the IRS. Specifically, you must file an application to be designated as an “S” corporation. The application in question is Form 2553. This form must be filed within 2 and ½ months of the creation of the entity or in the year prior to the year you wish the designation to be made. Prior to filing the designation, of course, you must have your employer identification number. This can be obtained with Form SS-4.
It is important to remember that there are restrictions on what corporations can file as “S” with the IRS. The designation is only available to small business corporations that are domestically formed. Further, the corporation can have no more than 100 shareholders and all must unanimously agree to the election. The shareholders cannot be other businesses, although there are some exceptions where business trusts are involved. A shareholder also may not be a non-resident alien. Finally, the corporation may only have one class of stock, although voting rights may differ.
One area where state law can cause problems with the s-election is in the field of community property. Certain states like California view marriage as conveying certain rights to both spouses whether they realize it or not. If you live in such a state, your non-involved spouse must also consent to the “S” election or it may be ruled invalid. Why? They essentially own part of your share position in the corporation.
Making the “S” designation for a corporation is not overly difficult, but many new entities run into problems because they fail to take care of the designation in a timely manner. Make sure you stay on top of the filing or you will have to wait for an additional year to make the designation.
Richard A. Chapo provides California incorporation services via http://www.SanDiegoBusinessLawFirm.com
Tags: 2553, c, corporation, entity, form, incorporate, irs, s, ss-4