C corporation and S corporation designations are designed for tax purposes. One does not become another without Internal Revenue Service authorization. A company starts out as a C corporation and retains that status until its owners file a request to be designated an S corporation. A company may remain a C corporation for as long as its management and shareholders desire. There is no limit to the initial designation.
As a C corporation, your company pays taxes through a corporate tax return, recording profits and losses. Shareholders of a C corporation pay taxes only on dividends they receive. Shareholders report the dividends as income, basically causing a double-tax on the profits. To avoid the double taxation, you can change your designation to an S corporation so that the company does not pay corporate taxes, which instead are reported on shareholders tax returns and paid at the level of the shareholders tax bracket. In effect, the company becomes a pass-through entity for tax purposes.
Shareholders also bear losses incurred by the corporation. Losses on gains above the basis of their original investment can be deducted from their tax returns. A few minor adjustments are allowed to correct the basis. It is the responsibility of the stockholder to track the basis of his holdings. When the corporation issues statements in the form of a Schedule K-1, the stockholder must determine the amount of his basis, or initial investment, prior to filing.
Some states do not recognize the tax differences between a C corporation and an S corporation. You must file corporate tax returns and pay state taxes on the company’s earnings. In those states, you’ll follow the federal guidelines as an S corporation and file as a C corporation with your state. Other states that recognize the S corporation designation continue to tax both the company and the shareholders, effectively canceling out the tax benefits on the state level. Various other rules in place in other states require S corporations to pay partial taxes.
To form an S corporation, you must file a Form 2553 with the IRS. As an owner of a company with an S corporation designation, you must take a salary from the company that is reasonable and fair according to the local market and incur payroll taxes on the salary. Both S and C corporations may provide tax-free benefits to employees that are deductible by your business. Shareholders of an S corporation who are employees and own more than 2 percent of the company’s stock, on the other hand, do not share the same flexibility. Not all of the fringe benefits received by those shareholders are tax-free. Additionally, shareholders of stock in an S corporation must be U.S. citizens, while C corporation investors can be more diversified.
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