Income Tax Features of S Corporations

A business that meets the following criteria (and certain other conditions) can elect to be treated as an S corporation: the business has issued only one class of stock, it has 100 or fewer people holding its stock shares, and it has received approval for becoming an S corporation from its stockholders.

Suppose that a business elects to be taxed as an S corporation. Its abbreviated income statement for the year is as follows:

Abbreviated Annual Income Statement for an S Corporation
Sales revenue	$26,000,000
Expenses, except income tax	(23,800,000)
Earnings before income tax	$2,200,000
Income tax	0
Net income	$2,200,000

Given the complexity and changing nature of the income tax law, the following discussion avoids going into details about income tax form numbers and the income tax rates used to determine the income tax amounts in each example.

An S corporation pays no income tax itself, as you see in this abbreviated income statement. But it must allocate its $2.2 million taxable income among its owners (stockholders) in proportion to the number of stock shares each owner holds.

If you own one-tenth of the total shares, you include $220,000 of the business’s taxable income in your individual income tax return for the year, whether or not you receive any cash distribution from the profit of the S corporation. That probably pushes you into a high income tax rate bracket.

When its stockholders read the bottom line of this S corporation’s annual income statement, it’s a good news/bad news thing. The good news is that the business made $2.2 million net income and does not have to pay any corporate income tax on this profit. The bad news is that the stockholders must include their respective shares of the $2.2 million in their individual income tax returns. An S corporation could distribute cash dividends to its stockholders, to provide them the money to pay the income tax on their shares of the company’s taxable income that is passed through to them.

The main tax question concerns how to minimize the overall income tax burden on the business entity and its stockholders:

Should the business be an S corporation (assuming it qualifies) and pass through its taxable income to its stockholders, which generates taxable income to them?
Or, should the business operate as a C corporation (which always is an option) and have its stockholders pay a second tax on dividends paid to them in addition to the income tax paid by the business?

Here’s another twist: In some cases, stockholders may prefer that their S corporation not distribute any cash dividends. They are willing to finance the growth of the business by paying income tax on the taxable profits of the business, which relieves the business from paying income tax.

Many factors come into play in choosing between an S corporation and a C corporation. You may want to consult a CPA or other tax professional for advice.