An "S" corporation passes its income through to its owners, so that the entity itself does not pay income taxes. The owners report the income on their tax returns, thereby avoiding the double taxation that arises in a regular "C" corporation.
The income distribution from an "S" corporation is on a per share owned basis. However, if an investor's holdings in the entity are for a partial year, then the income distribution is made based on shares held per day, through the fiscal year of the entity. The income distribution to a deceased investor is based on that person's ownership percentage through his or her date of death.
Some additional points regarding the "S" corporation are:
- There can be no more than 75 shareholders, so this approach is most suitable for smaller entities.
- All of the shareholders must agree to adopt the "S" corporation structure.
- Every shareholder must be a United States resident or citizen.
- A "C" corporation or a partnership cannot be a shareholder, though estates and certain trusts and charities can be investors.
- There can only be a single class of stock, which prevents preferential payments and voting privileges.
Tax Payments by an "S" Corporation
An "S" corporation may still have to pay taxes under the following circumstances:
- It has accumulated earnings from an earlier time period as a "C" corporation, and at least 25% of its gross receipts are from passive income
- It has certain types of capital gains
- It has recaptured an investment tax credit
- It has experienced a LIFO recapture situation
However, an "S" corporation is not affected by the alternative minimum tax.
How to Terminate an "S" Corporation's Status
If the owners or management of an "S" corporation want to switch to a different organizational structure, more than 50% of the shareholders must agree to this in writing. There must also be a statement by the entity, pointing out the same intent.
If there is an interest in reverting to "S" status at some later date, the owners are forced to wait at least five years before they can do so, unless they want to apply to the IRS for permission to do so at an earlier date.