An S election merely terminates the corporate taxpayer’s separate identity. The income then flows through to the shareholder owners who then receive a K-1 form which is filed with their individual tax return. This election is for tax purposes and does not affect the structure or operations of the corporation with third parties. It is not available to all corporations and there are timing rules with regard to making the election. The electing corporation must a domestic corporation(one not formed under the laws of a foreign government), not an ineligible corporation(not a financial institution, insurance company or a domestic international sales corporation), not a member of an affiliated group(not a parent or subsidiary corporation in a group of corporations which can file a consolidated return), have a limited number of shareholders(100) which must be individuals, estates or certain trusts, and outstanding stock may differ only in voting rights(one class of shares). It files an informational return. The shareholders pay a level tax rather than the two step tax paid by the C corporation and its employees and shareholders, can use a cash method of accounting unless it has inventory. There are passive income limitations for income from rent, dividends, interest or other passive income as opposed to income from the operation of a business. Passive rent is distinguished from rental income from as active business of renting property. If the corporation provides significant service in return for the payments it is not passive income. If passive income exceeds 25% of the gross receipts (not income) the election can be lost, depending on the distributions of the income and the number of years that it continues (there must be a three year phase out in order to retain the election). There is flexibility to set salaries for employee owners to reduce Social Security and Medicare taxes. Reasonable compensation must be characterized as wages with appropriate withholdings. The balance can be characterized as dividend income which is not subject to withholdings.
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