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# S Corporations

A business that meets the following criteria (and certain other conditions) can elect to be treated as an S corporation. A corporation that doesn’t qualify as an S corporation is a C corporation in the tax law. To be an S corporation, a business must meet these criteria:

• It has issued only one class of stock.

• It has 100 or fewer people holding its stock shares.

• It has received approval for becoming an S corporation from all its stockholders.

Suppose that a business qualifies and elects to be taxed as an S corporation. Its abbreviated income statement for the year is shown. 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 regardless of whether you receive any cash distribution from the profit of the S corporation.

That’s likely to push you into a high income tax rate bracket.

## The pros and cons of S corporations

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 doesn’t 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 on their individual income tax returns for the year.

The total amount of individual income tax that would be paid by the stockholders as a group is tough to pin down. Each investor’s tax situation is different. An S corporation could distribute cash dividends to its stockholders, which would provide them with the money to pay the income tax on their shares of the company’s taxable income.

## Choices regarding taxation for S corporations

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’re willing to finance the growth of the business by paying income tax on the taxable profits of the business — without taking a distribution from the S corporation.

This strategy relieves the business of making cash distributions to pay the income tax. Many factors come into play in choosing between an S and C corporation. Choosing the best option isn’t easy. Consult a CPA or other tax professional before making your final decision.