An S corporation (or S Corp), for United States federal income tax, is a closely held corporation (or, in some cases, a limited liability company (LLC) or a partnership) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
[3] The S corporation rules are contained in Subchapter S of Chapter 1 of the Internal Revenue Code (sections 1361 through 1379).
The United States Congress, acting on the Department of Treasury's suggestion of 1946, created this chapter in 1958 as part of a larger package of miscellaneous tax items.
[4] S status combines the legal environment of C corporations with U.S. federal income taxation similar to that of partnerships.
As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made.
[5] With modern incorporation statutes making the establishment of a corporation relatively easy, firms that might traditionally have been run as partnerships or sole proprietorships are often run as corporations with a small number of shareholders in order to take advantage of the beneficial features of the corporate form; this is particularly true of firms established prior to the advent of the modern limited liability company.
[11] Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
[12] A single class of stock means that all outstanding shares of stock confer "identical rights to distribution and liquidation proceeds," i.e. profits and losses are allocated to shareholders proportionately to each one's interest in the business.
An S corporation's election will also terminate if, for each of three consecutive years, (i) its passive investment income exceeds 25% of gross receipts and (ii) it has accumulated earnings and profits.
[citation needed] Widgets Inc., an S Corp, makes $10,000,000 in net income (before payroll) in 2006 and is owned 51% by Alex and 49% by Jesse.
The corporation must complete a Schedule K-1 for each person who was a shareholder at any time during the tax year and file it with the IRS along with Form 1120S.
As is the case for any other corporation, the FICA tax is imposed only with respect to employee wages and not on distributive shares of shareholders.
Although FICA tax is not owed on distributive shares, the IRS and equivalent state revenue agencies may recategorize distributions paid to shareholder-employees as wages if shareholder-employees are not paid a reasonable wage for the services they perform in their positions within the company.
The IRS intends to use the results to measure compliance in recording of income, deductions and credits from S corporations, and to formulate future audit criteria to better target likely non-compliant returns.
This is part of a larger IRS effort to improve tax compliance and reduce the estimated $300 billion gap in gross reported figures each year.
S corporations pay a franchise tax of 1.5% of net income in the state of California (minimum $800).