Although tax reporting is probably not a sufficient motivation for incorporating a business, the move to a corporate structure will bring with it unavoidable tax consequences. Your ability to control those consequences begins with the type of corporate structure you choose for your business.
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For tax purposes, corporations fall under two general categories named according to the subchapter of the I.R.S. tax code that describes them: Subchapter C and subchapter S corporations.
Unless otherwise designated, the I.R.S. assumes all corporations are Subchapter C corporations, which means they are subject to federal corporate income taxes. The problem is that C corporations are susceptible to a "double taxation" scenario because both the corporation and the shareholders (a.k.a. business owners) are forced to pay taxes as the business' profits change hands from the corporation to the business owner.
S corporations, on the other hand, are exempt from federal corporate income taxes. Instead, the company's profits (or losses) are taxed directly on the shareholders' personal returns. S corporations are especially attractive to small business owners because they circumvent the possibility of double taxation and offer the best of both worlds: The protection of a corporate structure along with the tax advantages of a sole proprietorship or partnership.
S corporations do have some disadvantages. For example, unlike other corporations, S corporations are prohibited from retaining earnings in the business since all of the company's profits are passed through to the owner(s). Also, S corporations may limit the fringe benefits that can be offered to employees.
To qualify as an S corporation, your business must meet the following criteria:
- It must be a U.S. corporation and have no more than 75 shareholders.
- All shareholders must be U.S. citizens or legal aliens living in the U.S.
- It must issue only one class of stock (e.g. common stock).
- The corporation is prohibited from owning more than 80% of another corporation.
- All shareholders must agree to the S corporation designation in writing as part of the application process.
To apply for an S corporation designation, you will need to complete and file I.R.S. form 2553 – Election by Small Business Corporation. There is a time window for the filing this form, so you'll need to do some research to make sure you are in compliance. You will also need to collect the signatures of the relevant corporate officers and the shareholders of the corporation.
Your application will be invalid unless it is signed by every shareholder. If you are just starting your corporation, you'll want to collect the signatures of the corporation's potential stockholders, even if some of them never actually fill this role.
Finally, before you make the jump to an S corporation, consult your tax advisor. Corporate taxation is a complicated topic, and the more information you have going into it, the better off you – and your business – will be.