An S corporation is a regular corporation that has elected 'S corporation' tax status. An S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partnership.

In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money that they draw from the corporation as salary, bonuses or dividends. By contrast, in an S corporation, all business profits and losses 'pass through' to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships and LLC). The S corporation itself does not pay any income tax, although a co-owned S corporation must file an informational tax return like a partnership or LLC -- to tell the IRS what each shareholder's portion of the corporate income is.

Most states follow the federal pattern when taxing S corporations: They don't impose a corporate tax, choosing instead to tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, tax an S corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

Should You Elect S Corporation Status?

If your corporation meets certain criteria, such as having only shareholders who are U.S. citizens or residents, you can elect to do business as an S corporation. Operating as an S corporation rather than a regular corporation may be wise for several reasons:

- An S corporation generally allows you to pass business losses through to your personal income tax return, using it to offset any income that you (and your spouse, if you're married) have from other sources.
- When you sell your S corporation, your taxable gain on the sale of the business can be less than if you operated the business as a regular corporation.

But aside from the benefits, S corporations impose strict requirements. Here are the main rules:

- Each S corporation shareholder must be a U.S. citizen or resident.
- S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
- An S corporation shareholder may not deduct corporate losses that exceed her 'basis' in her stock -- which equals the amount of her investment in the company plus or minus a few adjustments.
- S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.
- Fortunately, your decision to elect to be an S corporation isn't permanent. If you later find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time or by violating one of the above requirements.

How to Elect S Corporation Status

To be treated as an S corporation, all shareholders must simply sign and file IRS Form 2553. Shareholders then pay income tax on their share of the corporation's income whether or not they actually receive the money. If the corporation suffers a loss, shareholders can claim their share of that loss.

Advantages of S-Corporation Status

One of the main advantages of S-Corporation status is that it avoids the double taxation that occurs with a regular C-Corporation. In a C-corporation, the corporation pays income tax on its profits and, if those profits are distributed to shareholders, the shareholders pay income tax on the distribution i.e. dividends.

Electing S-Corporation status passes the income or losses of the corporation to the shareholders who recognize the income or loss on their personal tax returns. This is an advantage if the corporation expects to show a loss at first. The loss can be used to offset the shareholder's income from other sources, including a spouse's income.

Disadvantages of S-Corporation Status

Passing income through to shareholders can be a disadvantage in some instances. If the business is profitable, shareholders will be required to pay income tax on their share of the profits, even if that money is not distributed to them. In a C-Corporation, profits can be used to expand the business and shareholders are not required to pay taxes until distributions are made.

Reasonable salaries paid to employees are deductible business expenses for S-Corporations as well as for C-corporations. However, in an S-Corporation, fringe benefits may not be deductible as they would be in a C-Corporation.

Even though losses pass through to shareholders in an S-Corporation, those losses aren't deductible by shareholders who don't materially participate in the business. This could result in higher taxes overall.

S-Corporation Requirements

Not every corporation qualifies for S-Corporation status. In order to elect S-Corporation status, the corporation can only have one class of stock. The corporation can have no more than 75 shareholders, although a husband and wife who both own shares will only be counted as one shareholder. No shareholder can be a nonresident alien or another corporation. All of the shareholders must consent to elect S-Corporation status. The corporation also cannot earn too much of income from investments

HOW DO I KNOW AN S-CORPORATION IS RIGHT FOR ME?

- You have fewer than 75 shareholders.
- You are not doing a real estate investment business.
- You have a sales or service type of business.
- All shareholders are citizens or permanent residents of the U.S.
- You do not want personal liability for the company.
- You have sole ownership of the company.