Business Entity: Sub Chapter S-Corporation

In Illinois, all corporations are formed in the same manner. If an “S” Corporation - or "S" Corp - status is desired, a Form 2553 – Election to be taxed as an “S” Corporation is required to be filed with the Internal Revenue Service. This form is required to be signed by all shareholders and must be filed within 75 days of the earliest of:

  1. Having shareholders
  2. Having assets, or
  3. Doing business

In the event that an “S” election is filed after being a “C” Corporation, special care needs to be exercised and will be discussed later in another area.

The “S” election basically states that the shareholder will report their proportionate share of income (based upon the percentage of shares held) whether or not the income was distributed.

For example, if an “S” Corporation had $200,000.00 in income and on the last day of the year, purchased $200,000.00 in machinery, there would be no cash available for distribution. However, due to specific limits the corporation would have $42,000.00 in taxable income calculated as follows:

    Total Income before Asset Acquisition  $200,000.00
    Less Section 179 Expense Deduction ($102,000.00)
    Less 50% bonus Depreciation
    (98,000 x .50)
    (  $49,000.00)
    Regular Depreciation (per MACRS table)     $7,000.00

    Taxable income   $42,000.00

Basically, this shareholder (provided the individual owned 100% ownership of the corporation) would have to pay tax on $42,000.00 when no funds were disbursed.

The shareholder would eventually “recapture” the income via depreciation deductions on the equipment over the next 7 years. During that period, deductions totaling $42,000.00 would be allowed but cash would not be needed to fund the deduction.

The greatest advantage to an “S” Corporation is the “flow through” of income to its shareholders. It is also a disadvantage with the “flow through” of deductions.

A little history on “S” Corporations: Prior to 1958, small business owners wanted the legal protection that regular corporations had, but did not want the “double taxation” that these corporations require. In 1958 Congress enacted Sub Chapter “S” of the Internal Revenue Code. This act allowed corporate protection without double taxation.

“S” Corporation’s were subject to limitations regarding the number of shareholders, the type of shareholder and the type of income they could report. These limits have substantially changed over the past 45 years. Currently the following limitations are in effect.

  1. Quantity of Shareholders – 100 (All related family members can be deemed one shareholder.)
  2. New “S” Corporations – No Passive Income Limits
  3. Type of Shareholder’s substantially expanded

When this act was passed, a substantial number of businesses incorporated and elected “S” status. Please keep in mind that during that period the Internal Revenue Code had two maximum levels of taxation. The first level was based upon earned income - such as salary, wage, tips and earnings from self-employment. The maximum tax rate was 50%. Unearned income, which includes interest, dividends, rent, royalties and capital gains, was taxed at a maximum rate of 70%.

When the courts ruled that “S” Corporation earnings were deemed ”unearned income” subject to the 70% maximum rate, most newly formed corporations reverted back to sole proprietorships and partnerships.

In 1981, President Reagan proposed and congress approved a maximum tax rate of 50% on all income. When that law passed, a substantial number of “S” corporation were again formed.

In 1982, congress realized that the law allowed abuses. Since all ”S” Corporation earnings were deemed distributed and taxed to the shareholders, the officer/ shareholders did not pay themselves any salary. As such, they avoided all payroll taxes on these earnings.

In addition, there were no restrictions for an ”S” Corporation electing a fiscal year. Many professional tax advisors established “S” Corporations with fiscal years ending in January, February or March.

Since profits were not determined until the last day of the corporation’s fiscal year, an “S” Corporation shareholder whose corporation had a March 31st fiscal year end would not report or pay tax on these earnings until April 15th of the following year.

The 1982 Sub Chapter “S” Revenue Act eliminated several provisions which allowed these abuses.

One of the major provisions of this act, enabled the IRS to allocate reasonable compensation for “under compensated” Shareholders. The law specifies “If an individual is a member of the family of one or more shareholders of an “S” Corporation, renders services for the corporation or furnishes capital to the corporation without receiving reasonable compensation, therefore the Secretary shall make such adjustments in the items taken into account by such individual and such shareholder as may be necessary in order to reflect the value of such services or capital.”

This is the primary source of savings for an “S” Corporation shareholder.

With a “C” Corporation, you want to pay all profits as salary in order to avoid double taxation. With an “S” Corporation, you need to pay a reasonable compensation in order to protect the remaining corporate earnings from employment taxes.

There is always a risk that the salary paid will not be considered “reasonable” by the Internal Revenue Service, however the evaluation of “what is reasonable” is subjective and is subject to the facts and circumstances of each case.

A detailed review of the potential savings is available if needed.

In summation, “S” Corporations do the following:

Advantages of an S-Corporation:

  1. Separate entity
  2. Corporate protection
  3. Single taxation
  4. Potential reduction of employee taxes

Disadvantages of an S-Corporation:

  1. Benefits “flow through” to shareholder as personal expenses
  2. Health insurance reported as income, but not subject to payroll tax
  3. Husband and wife are considered one taxpayer (no medical insurance premium deducted)
  4. Certain family members can be classified as "one" shareholder.
  5. Profits distributed on shares held - not subject to alteration other then by payroll
  6. Profits taxed whether or not distributed