S Corporation or C Corporation
A corporation has a choice of how it wants to be taxed. It can make the election at the beginning of its existence or at the beginning of a new tax year. The choices follow.
Formerly called a "Sub section S corporation," an S corporation pays no income tax and may only be used for small businesses. All of the income or losses of the corporation for the year are passed through to the shareholders, who report them on their individual returns. At the end of each year, the corporation files an information return, listing all of its income, expenses, depreciation, etc., and sends each shareholder a notice of his or her share as determined by percentage of stock ownership.
Using this method avoids double taxation and allows the pass-through of losses and depreciation. For tax purposes, the business is treated as a partnership. Since tax losses are common during the initial years due to start-up costs, many businesses elect S status and switch over to C corporation status in later years. Be aware that once a corporation terminates its S status, there is a waiting period before it can switch back. Typically, S corporations do not have to pay state corporate income tax.
If stockholders are in high income brackets, their share of the profits will be taxed at those rates. Shareholders who do not materially participate in the business cannot deduct losses. Some fringe benefits, such as health and life insurance, may not be tax deductible.
To qualify for S corporation status, the corporation must:
- Be a domestic corporation
- Have no more than one hundred shareholders
- None of whom are nonresident aliens or corporations
- All of whom consent to the election (shares owned by a husband and wife jointly are considered owned by one shareholder)
- Have only one class of stock
- Not be a member of an affiliated group (only individuals, estates, and certain exempt organizations and trusts qualify)
- File IRS Form 2553 no more than two months and fifteen days after the start of the tax year for which it is to be effective, and be approved by the IRS
A C corporation pays taxes on its net earnings at corporate rates. Salaries of officers, directors, and employees are taxable to them and deductible to the corporation. However, money paid out in dividends is taxed twice. It is taxed at the corporation's rate as part of its profit, and then at the individual stockholders' rates as income, when distributed by the corporation to them.
If taxpayers are in a higher tax bracket than the corporation and the money will be left in the company for expansion, taxes are saved. Fringe benefits, such as health, accident, and life insurance, are deductible expenses.
Double taxation of dividends by the federal government can be a big disadvantage. Also, most states have an income tax that only applies to C corporations and applies to all income over a certain amount.
As a separate legal entity, a corporation must submit a tax return each year with the IRS. For C corporations with a fiscal year ending December 31, tax returns are due on April 15. For S corporations with a fiscal year ending December 31, tax returns are due on March 15. A corporation must file a tax return even if it does not have income or no tax is due.
Some states, including California, also have a state corporate income tax. Corporations with employees are required to pay federal (and sometimes state) payroll and unemployment taxes.
NOTE: Neither of these taxes applies to money taken out as salaries. Many small business owners take all profits out as salaries to avoid double taxation and state income tax. However, there are rules requiring that salaries be reasonable. If a stockholder's salary is deemed to be too high relative to his or her job, the salary may be considered to be partially a dividend and subject to double taxation.
NOTE: All corporations are C corporations unless they specifically elect to become S corporations.