Entities That Can Use. Corporations (one or more owners), general partnerships, [limited partnerships, perhaps] and limited liability companies (one or more owners) may select this type.

Main Characteristics. The central characteristics of S taxation are that (1) there is no entity level tax, but (2) there are significant restrictions on who may be owners. There can be no more than 75 owners, there can only be one class of stock, and the owners must (generally) be natural persons (not other entities or trusts). All of the earnings of the entity are taxed to the owners each year, when made, so there is less tax-deferred ability to accumulate earnings for acquisitions and the like.

S taxation provides the second highest level of deductible fringe benefits, such as health, life insurance and such, but the lead over other tax types has been consistently narrowing. S taxation provides a clear mechanism for dividing entity earnings between salary income for work done and dividend income for investment return. The salary component (on which the self-employment tax must be paid and which is generally subject to a higher income tax rate than dividends) must be within the range of a reasonable salary were the business to hire a third person to do the job with the knowledge and skills of the owner. Note that the IRS believes many owners and their tax return preparers are fraudulently allocating too low salaries; the IRS is auditing for this.

Contributing property to, and taking property out of, an S taxation entity is treated as a taxable event; often, a capital gain is triggered on dissolution of an S taxation entity.

Uses. S taxation is used by those who can meet its shareholder (owner) requirements now and in the future, who want the flexibility of pass through taxation, who desire the possible reduction in self-employment tax, and who do not fear the possible capital gain on dissolution of (or the owner’s exit from) the entity. 

This memorandum contains general information and while the information presented is accurate as of the date of its publication, it cannot be relied upon as legal advice, as that can only be obtained through personal consultation with an attorney with whom you share your specific facts.

 Copyright © 2005 by Sterling A. Minor. All Rights Reserved.

Last Updated: May 17, 2005