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California Business Law: S Corporations Explained

By Scott Kauffman, A California Tax Lawyer.

Many business planners are attracted to the idea of incorporation because of the protection it offers the corporation’s owners and operators from individual liability for the debts of the corporation. But there is a drawback to incorporation as well. Corporations are treated like individuals by the law and thus are taxed as an entity separate from their owners, the shareholders. In other words, the corporation first pays taxes on the corporation’s income, then if any earnings are distributed to shareholders, the shareholders must pay income tax as well. The “S Corporation”, so called for the section of the Internal Revenue Code on which it is based, is an alternative which eliminates this “double tax” consequence of doing business as a corporation. Not all businesses qualify for “S corporation” status and there may be other alternatives that better suit your business needs. Consulting with a tax attorney can be an invaluable first step to exploring the many organizational options available to businesses today. For some taxpayers with tax problems, the best solution is to pay the tax. If the taxpayer is self-employed, the taxpayer can substantially increase his after-tax cash flow by incorporating and electing to be taxed as an S Corporation. While the owner continues to be subject to income tax, he is no longer subject to self-employment tax or social security tax. The taxpayer can then apply this tax savings to the payment of old taxes.

The S Corporation of Today
A corporation is basically treated as though it were a person. It can sue and be sued, make contracts, own property and otherwise conduct business. The fact that the corporation is a separate legal entity gives rise to one of the greatest advantages to incorporation. The corporation is liable for the corporation’s debts. Shareholders are shielded from personal liability as are officers and directors, absent any wrongdoing on their part.

An S corporation is organized and operated just like a regular corporation, except for the special treatment afforded it under subsection S of the Internal Revenue Code. With some limited exceptions the S corporation is not taxed at the corporate level. Instead it is permitted to pass income through to its shareholders, who must report the income on their federal tax returns. This is a significant advantage to the corporation because it could cut the total tax liability almost in half. But, corporations pay taxes at different rates than do individuals. In addition, certain deductions available to regular corporations are not available to S corporations. If the corporate rates are lower than the individual rates and the corporation does not intend to distribute after-tax income to shareholders, then being taxed as a regular corporation may be an attractive option.

Not only are S corporation profits “passed through” to the shareholders, but, generally speaking, when a the S corporation loses money, the loss is passed through to the shareholders, who may deduct the loss from their income taxes. Tax credits due to the S corporation are passed through to shareholders as well.

S corporations must meet certain eligibility requirements. The special tax status of S corporations is meant for small businesses and, to this end, the law limits the number of shareholders in the corporation to 75. Among other requirements for eligibility, the corporation may only issue one class of stock, all the shareholders must be individuals, estates or certain types of trusts, and none of the shareholders can be nonresident aliens. The corporation must be incorporated under the laws of the Untied States. Certain kinds of corporations, such as banks and insurance companies, are not eligible at all.

S corporation status is available to both a new business at the time of incorporation, and an existing business with regular corporate tax status. Regular corporations previously taxed under section C of the Internal Revenue Code, may elect to become S corporations, but are subject to some limited restrictions on the ability to pass income and loss to the shareholders. A corporation elects to become an S corporation by filing a request with the Internal Revenue Service. Once the choice is made, it remains effective as long as the corporation meets the eligibility criteria above, or until the corporation, with the consent of the shareholders, revokes its S corporation status. Once S corporation election is terminated, the corporation cannot elect the status again for five years, although the IRS has the power to waive the waiting period if the termination was a mistake.

One of the most important business and income tax planning decisions facing a business planner is the choice of organizational form. This decision is seldom given the consideration it deserves even though the wrong choice can lead to unnecessarily higher taxes. New hybrid models, such as the S Corporation, expand the options but make choosing amongst the various options more complicated. A qualified business attorney can help you decide whether an S corporation is right for your business or whether a different organizational structure would better suit your specific business needs.

My Experience with S Corporations
I have extensive experience with S Corporations and all other forms of business entities and I can advise you of the business entity that works best for you.

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