Hooray for S Corporations!

The S corporation is often more attractive to small-businessowners than a standard (or C) corporation. That's because an Scorporation has some appealing tax benefits and still providesbusiness owners with the liability protection of a corporation.With an S corporation, income and losses are passed through toshareholders and included on their individual tax returns. As aresult, there's just one level of federal tax to pay.

A corporation must meet certain conditions to be eligible for asubchapter S election. First, the corporation must have no morethan 75 shareholders. In calculating the 75-shareholder limit, ahusband and wife count as one shareholder. Also, only the followingentities may be shareholders: individuals, estates, certain trusts,certain partnerships, tax-exempt charitable organizations, andother S corporations (but only if the other S corporation is thesole shareholder).

In addition, owners of S corporations who don't haveinventory can use the cash method of accounting, which is simplerthan the accrual method. Under this method, income is taxable whenreceived and expenses are deductible when paid.

S corporations do come with some downsides. For example, Scorporations are subject to make of the same requirementscorporations must follow, and that means higher legal and taxservice costs. They also must file articles of incorporation, holddirectors and shareholders meetings, keep corporate minutes, andallow shareholders to vote on major corporate decisions. The legaland accounting costs of setting up an S corporation are alsosimilar to those for a standard corporation. And S corporations canonly issue common stock, which can hamper capital-raisingefforts.

Gaining--and Revoking--S Status

A corporation must make the subchapter S election no later thantwo months and 15 days after the first day of the taxable year toelect. Subchapter S election requires the consent of allshareholders.

The states treat S corporations differently. Some statesdisregard subchapter S status entirely, offering no tax break atall. Other states honor the federal election automatically.Finally, some states require the filing of a state-specific form tocomplete subchapter S election. Consult an attorney in your stateto determine the rules that apply to your business.

An S corporation may revoke its subchapter S status by eitherfailing to meet the conditions of eligibility for S corporations,or by filing with the IRS no later than two months and 15 daysafter the first day of the taxable year. Once the revocationbecomes effective, the business will be taxed as a corporation.

S Corporations vs. LLCs

S corporations and LLCs possess similarities: They offer theirowners limited liability protection and are both pass-through taxentities. Pass-through taxation allows the income or loss generatedby the business to be reflected on the personal income tax returnof the owners. This special tax status eliminates any possibilityof double taxation for S corporations and LLCs.

That's where the similarities end. The ownership of an Scorporation is restricted to no more than 75 shareholders, whereasan LLC can have an unlimited number of members (owners). And whilean S corporation can't have non-U.S. citizens as shareholders,an LLC can. In addition, S corporations cannot be owned by Ccorporations, other S corporations, many trusts, LLCs orpartnerships. LLCs are not subject to these restrictions.

LLCs are also more flexible in distributing profits than Scorporations, wherein the corporation can only have one class ofstock and your percentage of ownership determines the percentage ofpass-through income. On the other hand, an LLC can have manydifferent classes of interest, and the percentage of pass-throughincome is not tied to ownership percentage. The pass-throughpercentage can be set by agreement of the members in the LLC'soperating agreement.

S corporations aren't without their advantages, however. Oneperson can form an S corporation, while in a few states at leasttwo people are required to form an LLC. Existence is perpetual forS corporations. Conversely, LLCs typically have limited lifespans.

The stock of S corporations is freely transferable, while theinterest (ownership) of LLCs is not. This free transferability ofinterest means the shareholders of S corporations are able to selltheir interest without obtaining the approval of the othershareholders. In contrast, member of LLCs would need the approvalof the other members in order to sell their interest. Lastly, Scorporations may be advantageous in terms of self-employment taxesin comparison to LLCs.

This article was excerpted from the books StartYour Own Businessand EntrepreneurMagazine's Ultimate Book on Forming Corporations, LLC's,Sole Proprietorships and Partnerships, and the article"S Corporations Vs. LLCs" by RickOster.