How S-Corporations are taxed
The term “S corporation” is an acronym that means a “small business corporation”
An S corporation is a closely held corporation or, in some cases, a limited liability company or a partnership that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.
S corporations are ordinary business corporations (or, in some cases, limited liability companies or even partnerships) that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379). S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.
Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. However, with modern incorporation statutes making the establishment of a corporation relatively easy, firms that might traditionally have been run as partnerships or sole proprietorships are often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form of business; this is particularly true of firms established prior to the advent of the modern limited liability company.
Thanks to this, the taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed.
Unlike a C corporation, an S corporation is not eligible for a dividends-received deduction. Additionally, unlike a C corporation, an S corporation is not subject to the 10 percent of taxable income limitation applicable to charitable contribution deductions.
A corporation is “eligible” to be an S corporation if it:
- Has no more than 100 shareholders,
- Has shareholders who are all individuals (exceptions are made for various tax-exempt organizations, estates, and trusts)
- Has no nonresident aliens as shareholders, and
- Has only one class of stock.
A limited liability company (LLC) is eligible to be taxed as an S corporation under the check-the-box regulations at § 301.7701-2. The LLC first elects to be taxed as a corporation, at which point it becomes a corporation for tax purposes; then it makes the S corporation election under section 1362(a)
S Corp Tax Rate
There is really no set tax rate for S-corporations. The reason why S corporations do not exactly have tax rates is that they don’t pay corporate income taxes.
Instead of being taxed upon the receival of profits derived from business operations, the shareholders are first allowed to take their share of the profits according to the amount of shares each shareholder possesses and their unique profit-sharing system.
To avoid double taxation, S corporation individual shareholders report the company’s profits (or at least their share of it) in their personal tax returns after sharing the profits and losses amongst themselves.
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