An S corporation is formed in the same way a C corporation is formed. The corporation must elect S corporation status, by filing Form 2553, Election by Small Business Corporations to Tax Corporate Income Directly to Shareholders. Form 2553 needs to be filed with the IRS on or before the fifteenth day of the third month of the corporationís taxable year. The election cannot be made before the formation of the corporation, and the board of directors of the corporation has to approve the election and note the approval in the minutes of the board of directors meeting.
S corporations are similar to C corporations in terms of business law, but not for federal income tax purposes. For those purposes, the S corporation is treated as a pass-through entity. That means that the entity itself does not pay any income taxes. The S corporation must file an information return, the Form 1120-S, U.S. Income Tax Return for an S Corporation. This form reports the income and deductions of the corporation. Part of Form 1120-S is a Schedule K-1 for each shareholder which shows their share of the corporationís net income or loss, along with any separately stated items. The shareholder uses the Schedule K-1 to report their business income or loss on their Form 1040. This income or loss is reported on Schedule E, Part II, Income or Loss From Partnerships and S Corporations.
Unlike partnerships and LLCs, S corporations will become taxpayers when they have any one or more of three certain types of income. These three types of income cannot be decreased by the use of any deductions. They are built-in gains, passive investment income, and LIFO recapture. Built-in gains are gains that are related to the appreciation of assets held by a C corporation that converted to S corporation status. Passive investment income is income of a corporation from the period that it was a C corporation. The S corporation will be taxed only when this passive investment income is greater than 25% of gross receipts. LIFO recapture exists when a C corporation that uses LIFO to report inventory converts to an S corporation. If the S corporation had never been operated as a C corporation in the past, none of these three types of income would ever be an issue.
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