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What is a subchapter ‘S’ Corporation and What are the advantage of S Corporation

By Jason Lee
Filed under: Corporations LLC         Words in this Post: 434



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The IRS classifies corporations by how they pay taxes. If you choose to incorporate your business, you’ll need to decide how to classify your corporation.

The S-type Corporation is the most common corporation used by most small businesses in the United States today. An S-type Corporation does not pay any taxes on its profits. Instead, all the profit or loss flows through the corporation to the stockholders (that’s you) and is taxed as ordinary income as opposed to “earned income.” This difference is important. “Earned Income” is salary and you have to pay Social Security and Medicare tax as well as federal income tax on it. “Ordinary income” is income from sources other than salary, such as your corporate income, and is not subject to Social Security and Medicare taxes. You only pay the basic federal income tax on this income.

Here is how the IRS distinguishes S Corporations from general, for-profit Corporations:

An S Corporation begins its existence as a general, for-profit corporation upon the filing of Articles of Incorporation. Once formed, a general for-profit corporation that has not requested “S Corporation Status” with the IRS will be required to pay income tax on taxable income generated by the corporation. In addition, any dividends distributed to shareholders may be subject to taxa-tion as dividend income to that shareholder as well (hence the problem of “double taxation” that can occur in a Non-S Corporation).

After the corporation has been formed, it may elect “S Corporation Status” by submitting IRS form 2553 to the Internal Revenue Service. Once this filing is complete, the corporation is taxed similarly to a sole proprietorship or partnership rather than as a separate entity. The income is now “passed-through” to the shareholders for purposes of computing tax liability. Therefore, each shareholder’s individual tax return will report the income or loss generated by the S corporation.

The final advantage of an S-Corp. is the fact that you are less likely to be audited. The IRS has a separate compliance and audit division for corporations. The IRS Corporate Audit Division has finite resources and can only do so many audits per year. Given their limited resources, they tend to go after the larger corporations where they can find larger amounts of money. This doesn’t mean you are audit-proof—it just means that, statistically, you have less chance of being audited as an S-Corp. than you do as a sole proprietor or a partnership. Again, your CPA can advise you if you are doing anything that would raise the “audit flag” with the IRS, and you can take the proper action to avoid this. Always follow your CPA’s advice.

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Author: Jason Lee

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