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.