Regular or "C" corporations pay
tax on their corporate income as a separate taxpaying entity. But the owners of a corporation can elect to be taxed under
Subchapter S of the Internal Revenue Code. An S corporation is one whose owners have elected not to pay any corporate tax
on its income. Instead, the shareholders elect to pay taxes on their respective shares of corporate income at their individual
income tax rates, even when income is not distributed to them.
An S corporation is similar to
a partnership in that both are tax conduits. The character of items of income, deductions, losses and credits passes through
to the shareholders. Although an S corporation does not usually pay a tax, it must file an annual return on Form 1120S.
Eligibility for S Status
Before a corporation can become
an S corporation, it must meet several requirements:
• It must be a domestic corporation.
• It must have 100 or fewer shareholders. Under the American Jobs Creation Act of 2004, up to six generations of lineal descendants
of the same family can be treated as one shareholder for S purposes. In the past, some corporations had been forced to terminate
their S status because younger-generation shareholders pushed the company beyond the maximum number of permitted shareholders.
• None of the shareholders may be a nonresident alien.
• The shareholders must all be individuals, estates,
certain types of trusts, qualified retirement plans, and charitable organizations exempt from income tax under IRC Section
• There must be only one class of stock issued and outstanding.
A corporation with, for example, both common and preferred stock would not be eligible.
S corporations may have subsidiaries
that are 80%-or-more-owned C corporations or wholly owned S corporations.
Election and Termination
If a corporation meets the eligibility
requirements, the election of Subchapter S status may be made by the corporation. The corporation, not the shareholders, makes
the election, but all the shareholders must consent. The corporation must file an election form (Form 2553) signed by the
person entitled to sign the returns. The form should be filed at any time during the preceding taxable year or on or before
the 15th day of the third month of the current taxable year for which the corporation wants the status.
All shareholders must consent
to the election, and the consents must be filed. Once the election is made, it is effective for the taxable year for which
it is made and for all following years, unless terminated.
The S tax status of a corporation
may be terminated by filing a revocation statement subscribed to by shareholders owning more than one-half of the stock. If
the revocation filing takes place on or before the 15th day of the third month of the taxable year, it is effective for that
taxable year unless another effective date is specified. If the filing takes place later, then the termination would be effective
the next taxable year, unless another date is specified.
Termination also occurs if any
of the eligibility requirements cease to be met. The termination is effective as of the date of the disqualifying event.
The IRS can waive invalid elections
(e.g., due to an inadvertent failure to get all of the necessary shareholder consents or to qualify for the S election), and
can also treat late elections as if made in a timely manner.
The American Jobs Creation Act
of 2004 provided relief from certain involuntary S terminations and invalid S elections.
Fringe Benefits for Shareholder-Employees
S shareholder-employees who own
2% or less of the corporate stock are generally treated the same as other employees for fringe-benefit purposes. When an S
shareholder owns more than 2% however, restrictions apply.
A basic authority in this area
is Rev. Rul 91-26, 1991-1 C.B. 184.
Medical Insurance Premiums
The premiums expended by an S
corporation for a more-than-2% shareholder-employee are includible in the individual's gross income, but 100% of such premiums
are deductible in 2003 and after.
Group-Term Life Insurance
While most employees may exclude
the cost of their group-term life coverage from gross income, the more-than-2% shareholder in an S corporation must include
the full cost of his or her coverage, even the first $50,000. The usual deductibility of the premiums is not affected.