Advantages of S Corporation Status

• The income of most corporations is taxed twice---the first time it is received by the corporation, and the second time when it is received by shareholders (as dividends, for example) and employees (salaries). The primary advantage of electing to be taxed under Subchapter S of the Internal Revenue Code is pass-through taxation---corporate income is not taxed at the corporate level. Furthermore, S corporation income is taxed at individual income tax rates (as opposed to sometimes higher corporation income tax rates). It is even possible for S corporation shareholders to deduct corporate losses form their personal income tax liability.
  
  

How to Become an S Corporation

• Not all companies qualify for S corporation status. It is possible, however, for qualified corporations and even LLCs to elect S corporation tax treatment by filing Form 2553 with the IRS. S corporations may not have corporate shareholders, and individual shareholders must be either citizens or permanent residents of the US. An S corporation may have no more than 100 shareholders, and many not issue more than one class of shares.
  
  

The Retained Earnings Pitfall

• Although S corporation income is not taxed until it reaches shareholders or employees, shareholders will be taxed on S corporation profits whether they actually receive dividends from the corporation or not. Therefore it is not possible to prevent S corporation shareholders from being taxed on profits simply by retaining all earnings in the corporation. For this reason, S corporations have an incentive to distribute their profits, and shareholders might end up being taxed more on the revenue of highly profitable S corporations than they would have if the corporation had not elected S corporation tax treatment.
  
  

FICA and Self-Employment Tax

• S corporation profits are not subject to FICA and self-employment tax, but employees must pay these taxes on their personal income. Since many S corporations are small corporations with several shareholder-employees, some S corporations try to assign these employees unrealistically low salaries (making up the rest with generous dividends) in order to avoid these taxes. However, the IRS requires that S corporations be paid "reasonable" salaries so they cannot avoid taxes by simply re-characterizing their income as dividends. S corporation salaries are closely monitored by the IRS.