In many respects, the S corporate form is a hybrid entity.  For most legal purposes, except taxation, an S corporation respects its lineage and is governed by the same laws that govern C corporations.    However, for tax purposes, S corporations display a tendency to be taxed similarly to partnerships.  This means that S corporate shareholders, like partners in a partnership, are taxed directly on their share of S corporation income, while generally the S corporation itself (like a partnership) reports no income taxes. Although the shareholder will be taxed once with certainty on S corporate earnings, this will be only instance in which corporation earnings are taxed.  Moreover, this proposition remains true whether or not the S corporation distributes its  earnings, since distributed earnings will constitute a tax-free return of basis to the shareholder.

This tax amnesty at the S corporate level, which leaves only one instance of taxation, at the shareholder level, best exemplifies the sea change in tax treatment where a C corporation elects S status, since C corporate earnings are normally taxed twice, first to the C corporation, and then again to the C shareholder when (and if) distributed, most likely as an ordinary income dividend. Tax is imposed on S shareholders in every year in which the S corporation reports (but pays no tax on) earnings, whether or not those earnings are actually distributed to S shareholders.  In contrast, C shareholders pay no tax until corporate earnings are distributed, either as dividends or in redemption of stock.  Although S shareholders are taxed immediately on corporate earnings, without the requirement, as exists in the C context, of there being an earnings distribution, S shareholders are nonetheless accorded the substantial tax privilege of inheriting from the S corporation the latter’s favorable income tax characterization.  For example, if the S corporation engaged in transactions that produced capital gains, those gains, as well as their characterization as capital gains, would flow through to S shareholders.  In contrast, dividends to C shareholders are characterized as ordinary income, and are therefore subject to higher tax rates, regardless of whether they had arisen from capital gains transactions at the corporate level.

S shareholders do not avoid reporting tax on corporate profits, but they do avoid reporting tax on corporate distributions, since the tax they incur on corporate profits increases their stock basis, which in turn permits those profits to be distributed tax-free.  Stock basis is also essential where an S shareholder wishes to report passed-through S corporation losses.  Although such losses flow through to S shareholders exactly as do corporate profits, losses are deductible only to the extent of the shareholder’s stock basis and the basis of any loan made by the shareholder to the S corporation.  To the extent losses exceed basis, the shareholder will be required to make a capital contribution or a corporate loan in order to deduct those losses currently.  Alternatively, unused losses may be carried forward until a future year when the S corporation reports profits.  In fact, if the shareholder expects to be in a higher tax bracket in the future, it may even be preferable to carry over losses to a later year.

Where differences in taxation exist, a partnership is generally taxed even more favorably than an S corporation.  However, liquidating an existing corporation in order to form a partnership may involve a high tax cost.  Similarly, liquidating a partnership (which cannot elect S status) and transferring its assets to a corporation may be costly.  It is therefore essential that small business owners contemplating the creation of a new business entity recognize that (1) favorable tax rules alone may not justify electing S status, since that objective could be accomplished more easily and more directly by choosing the partnership form, and (2) though important, tax savings alone may not justify the risk of personal exposure inherent in the partnership form.  Having said that, S corporate status might be an ideal vehicle for a start-up business that expects to lose money for the first few years.  Assume the following:  A group of ten investors each contributes $10,000 to develop real estate in Wyoming.  Since the partnership form is unappealing for nontax reasons, the business is incorporated, and S status is elected.

During years 1 through 4 the corporation incurs substantial start-up losses.  Those losses are passed through to the investor-shareholders.  (Had S status not been elected, those losses would have become “net operating losses,” frozen at the corporate level and carried forward until profits could offset them.)  During those years each S shareholder would be entitled to deduct his share of losses on his personal tax return, provided (1) the shareholder had sufficient stock or debt basis to cover such losses, and (2) the losses were not disallowed by the at-risk or the passive activity limitations on deductibility that apply to S corporations and their shareholders.  In year 5 the corporation turns a profit of $200,000, characterized at the corporate level as a capital gain. The corporation then distributes $20,000 to each shareholder.  The tax consequences in year five would entail (1) the S corporation itself reporting no income, but (2) each shareholder reporting $20,000 of capital gain on his tax return, after (3) adjusting his stock basis upward to reflect S corporation income, which upward basis adjustment would cause the distribution to be treated as a (4) tax-free return of capital.

Not every C corporation may elect S status, nor would this election be desirable in all cases in which it would be permitted.  In order to elect S status, a corporation must have no more than 35 shareholders, and must not have issued more than one class of stock.  Only individuals, estates and certain trusts may own S corporation stock; partnerships and corporations are ineligible S shareholders.  Lower corporate level tax rates apply to C corporations with up to $50,000 in income.  Consequently, if a C corporation in this lower tax bracket planned to retain earnings, electing S status in order to avoid shareholder taxation would probably be counterproductive since in this case it would result in a higher tax liability.