When a company is created, Subchapter S Corporation is established through the United States Internal Revenue Service and the 26 United States Code. In the spirit of allocation of profits and taxes, Subchapter S companies enjoy the status of both a business and a partnership under the law. Businesses strive to maximize the income generating potential while reducing the cost of operations as much as possible. Taxation is a requirement that to some extend is a burden to many businesses. It is due to high taxations in some countries that investors are resorting to business establishments in countries perceived as tax havens. The individual tax rates in the United States of America s substantially lower than the corporate taxation rate. The government uses lower tax rates to enhance the civilian potential in boosting individual economic status and attaining social progress. While subchapter S corporations benefit substantially from the provisions of both small the partnership and corporate status, limitations do exist. Investors intending to elect their corporations as Subchapter S Corporations ought to understand the structural and legal requirements for the election of Subchapter S corporations. This paper will embark on an in-depth analysis into the general provisions, tax treatment of the owners, and the special rules governing the formation and operations of Subchapter S Corporations.
Formation of Subchapter S Corporations
The United States Code 1362 provides for the election, revocation and termination of a Subchapter S corporation. A business recognized as small under the United States of America laws can fill form 2553 of the Internal Revenue Service. The United States of America’s internal revenue service is mandated with the collection of government revenues across the country. The tax rates, exceptions and special provisions for the various entities in the United States of America are structured and disseminated by the internal revenue service. In the case of giving a small business the Subchapter S corporate status, the Internal Revenue Service considers the eligibility of the given business for the Subchapter S status. Internal revenue Service under The Department of Treasury stipulates qualifications for a business to be elected as subchapter S corporations in the instructions of from 2553. The applying corporation must be a United States of America domestic entity or corporation (Internal Revenue Service, 57). A corporation should have a total number of hundred shareholders or less. However, the internal revenue code section 1361 sub-section C (1) (b) provides that members of a family can be deemed as a single shareholder. The shareholders in the applying corporation should be estates, individuals and selected organizations and trusts. The corporation should be composed of resident shareholders only with no alien shareholder. Also, the corporation should have a single category of stock, adopt a fiscal calendar ending December 31 and all members must consent to the subchapter S corporate election.
Upon the election of a corporate as a subchapter S corporate, termination of the status is imminent in given circumstances as provided in the law. Shareholders may terminate subchapter S corporate status of the business by revocation. By revocation, at least shareholders owning half of the stocks of the corporation should consent to the revocation application. In the event that a corporation ceases to be a small business, the subchapter S corporation status is terminated. Also, a corporation can lose the Subchapter S corporate status whenever the business makes income exceeding 25% of the total profits and earnings from passive investments in three consecutive years.
Subchapter S Corporation Shareholder Tax Treatment
The greatest advantage of a Subchapter s corporation is the ability to enjoy the limited liability of corporations and the individual taxation of a partnership (Pride, 34). The law thus, allows the shareholders of a Subchapter S corporation to be taxed at the individual rate. Shareholders in a subchapter S corporation can be employees in the corporation with accruable of tax-free benefits in terms of salaries and dividends. By distributing income as dividends and salaries, the owners reduce self-employment tax substantially while creating room for wage and business expense deductions. The provisions governing subchapter S corporations does not allow the entity to pay taxes but distribute the income to the shareholders. When the corporate makes losses, the loss distribution offsets the shareholder’s other incomes thus reducing the tax payable by shareholders (SHILLING, 67). Also, the transfer of interests in S corporations is quite ideal due to lenient tax consequences enshrined on individual taxation.
The determination of shareholder tax liability is guided by the provisions of the United States Internal revenue code 1366. The incomes, losses and deductions accruable to a shareholder are factored in the computation of federal tax payable (National Law Review, 17). The taxable items should fall within the financial year as stipulated in the formation of the subchapter S corporation. The law provides for the character pass thru in the taxation of shareholders where pro rata share is used. The treatment of the realization of income is on pro rata basis for all the shareholders. However, the law provides for the special rules to guide on the deductions and losses in S corporation. The accumulated losses and deductions accrued to a shareholder in a given financial year shall not exceed the shareholder’s debts and stock in the corporation. In this sense, the shareholders in subchapter S corporation are shielded from adverse losses and imminent bankruptcy.
Subchapter S corporation Special Rules
Several special rules shall guide the operations of subchapter S corporations to ensure a smooth blend of the provisions of a corporate and a small business. The special rules are enshrined in the 26 United States of America Code Part III. The partnership rules as stipulated in the partnership greed shall apply in the treatment of fringe benefits in a subchapter S corporation. The general rule is that, a subchapter S corporation is subject to a partnership treatment. In the definition of a partner, the law establishes that a partner include anyone with more than two percent stock or voting rights outstanding in a given taxable year shall be deemed as a partner. Foreign income and losses shall be treated as at the disposition of the business. In relation to built-in gains, the special rule governing the Subchapter S corporations indicates that a maximum rate shall be imposed on built-in gains. However, there is an allowance for operating losses from previous years carried forward in a S corporation. On passive income, special rules dictate that the maximum rate shall be applied on passive income that exceeds 25% of the gross income. In the event that passive income exceeds the gross total income for three successive years, the corporation ceases to be a subchapter S corporation.
Advantages of a subchapter S corporation
Several advantages accrue to a corporation operating as a subchapter S corporation. Subchapter S corporations enjoy single taxation as opposed to the normal corporations (Kahn, et al, 103). The profits made by the business are distributed to the owners who in turn pay taxes on individual rates. Double taxation occurs when a corporation pays corporate federal taxes and the shareholders also pay individual taxes on the distributed income. Shareholders working in a subchapter S corporation also avoid huge taxes imposed on individuals on self-employment as the S corporation enjoys the provisions of a corporation (Kulhan, et al, 79). Subchapter S corporations allow individuals to do small businesses and enjoy the provisions of big businesses. The limited liability of subchapter S corporations shields investors’ personal assets from being used to meet business debts in the case of insolvency (Zdenek, 19). The formation of a subchapter S corporation is quite simple as compared to a limited liability company. The documentation and requirements of a S corporation are flexible. The income is distributed as per the shares owned while owners also can be employees in the corporation. Also, the transfer of shares and interest in a subchapter corporation is quite easy as compared to transfer of credit in corporations that attract tax consequences (Alexander 37).
Shortcomings of a Subchapter S corporation
Despite the several advantages, certain shortcomings limit the operations and the capacity of a subchapter S corporation. The balance of characterizing wages and dividends in a subchapter S corporation has tax and deduction implications. The categorization of business distributed income as wages implies that the corporation will incur more money in terms of employment taxes. The payment of wages as dividends causes the business to lose deductions that accrue for compensations paid by the business (Rose, et al, 113). The formation of a subchapter S corporation requires due diligence. Mistakes in the notification, consent, and filing of requirements, stocks or election can lead to the termination of the subchapter S corporation status. Also, subchapter s corporations pay franchise taxes and report fees (Rupert, et al, 90).
Based on the information from the research paper, a lot can be deduced in relation to the formation, general guidelines, advantages and disadvantages of a subchapter S corporation. The law is quite explicit as far as the formation, operation and the termination of a subchapter S corporation is concerned. The provisions towards the election of a corporation to attain S corporation status are quite simple as far as the process is approached with precision. The United States of America laws provides an avenue for small business owners to further personal by allowing small businesses to enjoy the benefits of huge business status. The subchapter S corporation status could however, be a limiting factor in business operations. The maintenance of small business status can hamper growth as investors seek to retain the benefits of subchapter S corporation status. Also, subchapter S corporation status is limiting as far as passive income is concerned. From the paper, the advantages of subchapter S corporations are built on the ability to avoid rates that accrue from operating a business. Subchapter S corporations provide an opportunity for small investors to save on taxes and accrue incomes to develop into bigger corporations in the long-run.
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