S Corporation

An S Corporation is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code (enacted in 1958 and periodically amended) and receives IRS approval of its request for Subchapter S status. As a legal entity (an artificial person), the S corporation is separate and distinct from the corporation's owners (the stockholders).

Eligibility for S corporation tax status is based on compliance with IRS regulations regarding the number and characteristics of stockholders, type of stock issued, and other characteristics specified in the regulations. An S corporation can issue only one class of

Moderate legal costs are incurred in setting up a typical S corporation and annual costs are incurred for stockholders meetings, tax return preparations, and preparing other yearly reports and summaries as needed for management and as desired by stockholders. Public notice of the formation and continued operation of a corporation is required and is accomplished through filings with the Secretary of State's Office.

Limitations of the S Corporation:

• Lenders may require personal guarantees from corporate officers as a condition of supplying credit, thus negating the limitation of liability.
• Conflicts or disagreements among the stockholders (usually a small group of persons) may immobilize decision-making.
• Restrictions on the sale of stock and/or buy-back agreements included in the bylaws may prevent minority stockholders from being able to recover the value of their investment in the corporation.
• Through the processes of gifting and inheritance, stock ownership can become divided among many persons who are not active in the business and they may become a voting block that does not support needs and decisions believed desirable by managing stockholders.
• Over time, corporation paid benefits for stockholder-employees may become costly and exceed the ability of the business to pay.
• Employment benefits such as life insurance, health insurance, and housing costs are taxable income to stockholder employees with 2 percent or more stock ownership and to employees who are directly related to persons owning 2 percent or more of the corporation stock.
• If the corporation owns appreciated assets and the corporation is dissolved, significant income taxes on the appreciation amount will be generated.

The corporate shield of limited liability may be lost:

• When corporate formalities are not followed ? that is, when director and shareholder meetings are not held and minutes of such meetings are not kept.
• When corporate assets are treated as personal assets ? for example, when a corporate vehicle is used for family vacation and the corporation is not reimbursed for the non-business use.

When limited liability is lost, shareholders become personally liable for any corporate legal or financial obligations. In addition, if corporate income tax returns are audited, failure to observe corporate formalities or treating corporate assets as personal assets can result in loss of corporate income tax deductions and levying of penalties and interest on taxes assessed for previous years.