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Comparing S-corporation and C-corporation: Legal and Tax Aspects

LEGAL:

The following applies to all corporations:

For more about the legal aspects of a corporation, see Ten Attributes of a Corporation.

TAXES:

From a legal standpoint, a C-corporation and S-corporation are the same .

It is how C and S-corporations are taxed that distinguishes them.

The letters C and S refer to subchapters of the Internal Revenue Code (IRC) that govern their tax treatment.

C-corporations:

Newly created corporations are automatically subject to the tax rules under subchapter C of the Internal Revenue Code. In other words, all corporations start out as C-corporations.

A C-corporation is a tax-paying entity; it pays taxes on corporate income.

Income that is not distributed to stockholders is called retained earnings.

Stockholders only pay taxes on C-corporation income when it is distributed to them. Income that is distributed to stockholders is called a dividend.

Dividends are reported to the IRS and to shareholders annually on Form 1099-DIV.

C-corporation Losses:

Losses incurred by a C-corporation are deducted from C-corporation income of other periods. Losses do not pass through the entity to its stockholders.

S-corporations:

After initially incorporating your business, it takes one additional step to convert from a C-corporation to an S-corporation:

Form 2553, Election by Small Business S-Corporations to Tax Corporate Income Directly to Shareholders must be filed after the business has been properly incorporated.

After the IRS approves the change from C to S-status, the corporation is then subject to the tax rules under subchapter S of the Internal Revenue Code instead of subchapter C.

An S-corporation is not taxed.

An S-corporation is treated as a partnership for federal tax purposes. This means, like a partnership, an S-corporation is a tax-reporting entity not a tax-paying entity.

An S-corporation files Form 1120S to report income, expenses, gains, losses, and credits.

Income, deductions, gains, losses, and credits pass-through the S-corporation directly to its shareholders who report these items on their individual income tax returns.

Schedule K-1 is issued annually by the S-corporation to each shareholder reporting their share of income, deductions, gains, losses, and credits.

S-corporation losses:

Losses incurred by an S-corporation pass-through the entity to its stockholders who may deduct their share of the loss against their other sources of income reported on Form 1040.

When an S-corporation may be taxed:

There are three instances when an S-Corporation itself may be liable for taxes.

These instances may occur as a result of operating as a regular C-corporation for a period of time before electing S status.

An S-corporation may be liable for income taxes  upon converting from C status to S status for the following reasons:

  1. Built-in gains on appreciated property held by the corporation when it was a regular C-corporation:
    • The gain is the excess of the market value over the adjusted basis of the property at the date of conversion.
    • This gain is reported as a built-in-gain if the property is sold or disposed of within 10 years of the conversion.
  2. LIFO (Last-In, First-Out) recapture:
    • LIFO recapture is the excess of FIFO (First-in-First-Out) ending inventory over LIFO ending inventory.
    • This excess amount is the amount by which net income was understated as a result of using LIFO instead of FIFO.
    • This excess amount is recaptured as income and taxed to the S-Corporation.
  3. Passive invest ment income:
    • An S-corporation must pay tax on excessive passive investment income earned during a tax year when it operated as a C-corporation.
    • A tax results when passive investment income exceeds 25% of gross receipts.
    • Passive investment income includes: rents, royalties, dividends, interest, annuities, and proceeds from the sales or exchange of stock or other securities.
    • If all accumulated earnings and profits are distributed to shareholders before year-end, the corporation can avoid paying the tax. However, the shareholders will have a taxable dividend.

Note: If S status is elected and approved immediately after initially incorporating, the S corporation will never be subject to federal income taxes. However, some states may assess an annual minimum tax on the S-corporation.

Next:

S-corporations: How an S-corporation Deducts Health Insurance Premiums

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