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Delaware S Corp

A "Delaware S Corp / Delaware S Corporation" also known as a Subchapter S Corporation is an entity that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code by filing form 2553 with the IRS within the time afforded and by passing the eligibility “tests”.

  • Although we commonly refer to them as “S-Corporations” not all such companies are Corporations. LLC’s can elect “S-Status” too! In Delaware, an “S-Corporation” is not an entity type, it is a tax status (in some states an “S-Corporation” is both an entity type and a tax status).
  • A company typically elects S-Status to avoid the penalty of Double Taxation that would occur if the company were taxed as a regular Corporation (C-Corporation ).
  • “Double Taxation” occurs when C-Corporation income is subjected, first, to corporate income tax, and is then taxed a second time, as personal income, when corporate earnings which have already been taxed are returned to the shareholders in the form of dividends

How is an S-Corporation taxed by the IRS?

  • If S-Status is granted, company earnings are not taxed at the corporate level by the IRS; and are not subject to the corporate alternative minimum tax.
  • All corporate income passes directly through to the shareholders in proportion to their individual ownership of shares in the Corporation; this income is then taxed only once—at personal rates.
  • When we say “Pass Through” we mean that the income or losses of an S-Corporation are deemed to be the personal income or personal losses of its shareholders, reported on their personal tax returns.
  • Capital losses of the S-Corporation can be used by the shareholders to offset other personal income, providing that they do not deduct as a loss any amount exceeding their individual investments in, or loans to the Corporation tax basis.
  • Such losses may be carried forward indefinitely for possible later use if not currently usable.

How is an S-Corporation taxed by the Secretary of State of Delaware?

  • Respecting the annual tax paid by an entity to the Delaware Secretary of State for the purpose of maintaining a valid Charter issued by the State of Delaware, an S-Corporation is taxed in the same manner as a Corporation if it is registered as a Corporation and is taxed in the same manner as an LLC if it is registered as an LLC.

Who may elect “S” Status?

  • A Corporation or LLC is only eligible to elect “S” Status if it passes all of the following “tests”:
    • The Corporation or LLC must be Chartered in a US State of Territory, such as Delaware.
    • The Corporation or LLC must file Form 2553 on time. (For more information about the filing deadlines see IRS Publication i2553 “Instructions Filing Form 2553” at http://www.irs.ustreas.gov/pub/irs-pdf/i2553.pdf)
    • All of its shareholders must either be natural persons or estates of deceased persons in the process of administration. Other Corporations and partnerships are not permitted to be shareholders unless they are exempt under provisions such as 501(c)3 for Charitable Organizations; or unless they are an S-Corporation holding a 100% share of a subsidiary S-Corporation.
    • All of its shareholders must either be US Citizens or US-Resident Aliens. US-Resident Aliens must reside in a US state; Aliens resident in a US territory are not eligible. A non-resident alien cannot be a shareholder of an S-Corporation. An “alien” is also known as a “foreign national” or “non-citizen”.
    • The Corporation must have only one class of stock, although that class may be divided into Voting and Non-Voting shares. In the case of an LLC, all owner-members must have identical rights to distribution and liquidation proceeds.
    • The Corporation must not be a Section 585 bank, a subchapter L insurance company, a section 936 possession S-Corporation, nor a Domestic International Sales-Corporation or former DISC.
    • The Corporation must follow a calendar tax year unless it can justify a reason to do otherwise, such as seasonal business.
    • Each shareholder must consent to the S-Status election.
    • The Corporation must have less than 100 shareholders or LLC Members. In this case, a married couple who hold stock as “Tenants in Common”, “Joint Tenants”, or “Community Property” are counted as one shareholder; unless both spouses also hold shares of stock individually in addition to jointly, in which case they are counted as two shareholders; if only one spouse holds additional shares individually they are only counted as one shareholder. Two unmarried shareholders holding stock jointly are counted as two shareholders.

Caution: An existing S-Corporation will lose its tax status if any of the above rules are broken. Following are some examples of actions that could result in a company losing its S-Corporation status, this is not intended to be a complete or comprehensive list.

An S-Corporation may lose its S-Corporation status if:

  • Stock is sold or transfered to a non-resident alien.
  • Another Corporation purchase shares of the S-Corporation, with the exception of one S-Corporation holding 100 percent of a subsidiary S-Corporation.
  • The number of shareholders exceeds 100.
  • A second class of stock is issued. Note that if your S-Corporation's shareholders lend too much money to the Corporation, rather than investing the money in stock as capital at risk, the IRS may nevertheless deem the loan to be an investment in stock and rule that stock to be a different class than the one originally issued.
  • A Close Corporation is formed with stipulations in the Certificate of Incorporation and By-Laws which may prevent unintentional loss of S status due to sale or transfer of stock.

The S-Corporation as an alternative to the C-Corporation

What are the advantages of an S-Corporation ?

  • While LLC’s and “C-Corporations” may each be eligible to elect “S-Status”, for the purposes of this discussion, we are focusing on the S-Corporation as an alternative to the C-Corporation . Below are some features of the S-Corporation eligible entrepreneurs may consider advantageous:
    • You can pay yourself as high a salary as you wish without running the risk that the IRS will consider it “out of line with comparable salaries in your industry.”
    • If you have a one-person S-Corporation, you need not be concerned about the IRS deciding that you are “a personal holding company” and subject, therefore, to additional taxation. (This is a distinct hazard for one-person operators of some types of enterprises.)
    • Avoidance of double taxation of capital gains, should the Corporation or any of its assets be sold.
    • Stockholder employees of S-Corporations may participate along with other employees (or individually in the case of a one-person Corporation) in qualified retirement plans set up by the S-Corporation. Under the Tax Equity and Fiscal Responsibility Act (TEFRA), S-Corporations, C-Corporations and partnerships are treated with few significant differences with respect to qualified retirement plans. The S-Corporation can take a tax deduction for the full amount of its contribution to the plan. In the case of shareholder employees, the contribution made on their behalf must be reasonable when compared to compensation they receive. The employee (shareholder or not) is not required to include as income either the S-Corporation’s contributions or the subsequent earnings from the invested contributions until such time as he/she receives a distribution from the qualified plan.
    • S-Corporations are usually permitted to use the cash accounting system, which is the simplest. More than half of all small firms in the USA are taxed as S-Corporations.

What are the limitations of S-Corporation status?

  • Below are some features of S-Corporations that eligible entrepreneurs should be aware of when making the decision between an S-Corporation and a C-Corporation:
    • S-Corporations may own subsidiaries but they must not own more than 80 percent of a non S-Corporation subsidiary’s stock. They are permitted to own 100 percent of another S-Corporation.
    • Fringe benefits paid to shareholders who own two percent or more of the S-Corporation’s stock —such as medical reimbursement plans and group term life insurance—are not deductible corporate expenses under the latest federal tax laws, unless such expenses are reclassified as wage income to the greater than two percent owners.
    • While S-Corporation income is exempt from corporate tax at the federal level, not all states and territories exempt such Corporations from state (or territorial)corporate taxes. States and territories that do not recognize S-Corporation tax status of S-Corporations incorporated in and/or operating in their jurisdiction include: The District of Columbia ( Washington, DC), New Hampshire, and Tennessee. These jurisdictions require S-Corporations to pay state taxes at C-Corporation rates. Some states tax S-Corporations on part of their income, on capital gains and/or on “excess passive income”, such states include: Massachusetts, Indiana, Kentucky, Idaho, Maine and Wisconsin. Michigan, California, New Jersey and New York tax both the S-Corporation's profit and the shareholder's proportional shares of the S-Corporation's profits. In these states the S-Corporation is double-taxed in a manner similar to a C-Corporation that distributes all of its profits as dividends. The majority of the states impose state income taxes on the shares of income of S-Corporations operating in their state which pass through to shareholders who reside out-of-state. Some states, including Delaware, require that an S-Corporation withhold state income taxes from distributions to nonresident shareholders. (In addition to adding to the accounting/bookkeeping workload, this might result in non-pro rate distributions which in turn could lead to an I.R.S. finding that your Corporation has more than one class of stock, in which case it could cause a retroactive termination of your federal S-Corporation election.)
    • With an S-Corporation, shareholders are taxed on their shares of corporate earnings whether they take these earnings as dividend distributions or retain the earnings in the Corporation. All earnings (profits) must pass through to shareholders, at least on paper. In other words, even though the corporate profits for a given year remain physically in the corporate bank account – to build up working capital, for example – and are never transferred to the shareholder(s), each shareholder must nevertheless pay personal income tax on his/her share of those profits, which will be considered by the IRS to be: (1) individual income and (2) paid-in capital.

FAQ's on S-Corporations

Q: I'm probably not going to make any money my first couple of years in business due to start-costs, do I still have to pay taxes?

A: A company registered in Delaware must pay an annual tax to the Secretary of STate of Delaware to maintain its Charter issued by this state; this tax is not dependent on your activity level or profits. If you registered in any additional states you may owe a similar tax and/or annual filing fee in those states. If your LLC or Corporation is being taxed as a "Disregarded Entity", partnership or S-Corporation then your losses will "pass through" and may be claimed on your personal income tax return as an offset to other sources of income you may have. These losses may even be carried forward to future returns.

Q: In what circumstances is it particularly desirable to consider electing S-Corporation status?

A: If you already have or plan to start a one-person or closely held business or professional activity, with probably losses during the first year/second year start-up period resulting from initial investments in equipment doing business materials or inventory, heavy operating expenses, low sales or other income, etc. the S-Corporation permits the pass-though of operating losses to shareholders who may have income to offset such losses. If you already have a business with a hight taxable income that distributes the majority of its earnings as dividends and that has low capital spending requirements. Note: Any company that changes its corporation status generally is prevented by Federal tax law from switching back for five years.

Thank you for your interest in Delaware S corporations.

 

 



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