Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======S Corporations====== An S Corporation (or S Corp) is a special type of business structure, unique to the United States, that offers a clever blend of benefits from both the corporate and partnership worlds. At its heart, an S Corp is a regular corporation that has made a special election with the `[[Internal Revenue Service (IRS)]]`. This election allows the company's profits and losses to be "passed through" directly to the owners' personal income without being taxed at the corporate level first. This structure gives `[[shareholders]]` the robust `[[limited liability]]` protection of a corporation—meaning their personal assets are shielded from business debts—while enjoying the tax advantages of a `[[partnership]]`. It’s a popular choice for small businesses and startups that want to avoid the `[[double taxation]]` trap that often ensnares its more common cousin, the `[[C corporation]]`. For an investor, understanding the S Corp structure is crucial when analyzing smaller, privately-held companies, as it fundamentally changes how profits, taxes, and cash flow are reported and handled. ===== How an S Corp Works ===== Think of an S Corp as a regular corporation that has simply chosen a different way to file its taxes. To make this choice, a business must first be structured as a corporation (or a `[[Limited Liability Company (LLC)]]`, which can elect to be taxed as an S Corp) and then file a specific form with the IRS. However, not just any company can become an S Corp. The IRS has strict rules: * It must be a domestic corporation. * It can have no more than 100 shareholders. * Shareholders must be individuals, certain trusts, or estates (no partnerships or corporations as shareholders). * Shareholders must generally be U.S. citizens or residents. * It can only have one class of stock. Once these conditions are met and the election is approved, the magic of `[[pass-through taxation]]` begins. The S Corp itself files an informational tax return, but it doesn't pay federal income tax. Instead, the profits (or losses) are divided among the shareholders according to their ownership stake. Each shareholder then receives a `[[K-1 schedule]]`, which reports their share of the income, and they pay taxes on it at their individual income tax rate. ===== The Investor's Perspective ===== While you’re unlikely to find an S Corp trading on the New York Stock Exchange—due to the ownership restrictions—understanding them is vital for anyone investing in private or very small public companies. The distinction between an S Corp and a C Corp has significant implications for a `[[value investor]]`. ==== S Corps vs. C Corps: What Really Matters? ==== The most glaring difference is taxation. A C corporation pays tax on its profits. Then, if it distributes those profits to shareholders as `[[dividends]]`, the shareholders pay tax on that income again. This is double taxation. An S Corp neatly sidesteps this. All profits flow directly to shareholders and are taxed only once, as personal `[[ordinary income]]`. This has a profound effect on a company's ability to grow using its own cash. In a C Corp, `[[retained earnings]]` (profits not paid out as dividends) are reinvested back into the business after the corporation has paid tax on them. This is a powerful engine for compounding growth, famously utilized by `[[Warren Buffett]]` at Berkshire Hathaway. In an S Corp, the story is different. Because all profits are "passed through" for tax purposes, shareholders owe tax on their portion of the company's earnings //regardless of whether they actually receive that money in cash//. If the S Corp retains all its profits to reinvest for growth, the shareholders are left with a tax bill but no cash distribution to pay it with. This is often called "phantom income" and can create pressure on the S Corp to distribute cash, potentially limiting its ability to compound capital internally as efficiently as a C Corp. ==== Key Considerations for Value Investors ==== * **Analyzing Financials:** When comparing an S Corp to a C Corp, you aren't comparing apples to apples. An S Corp's "net income" figure is before the owner's personal taxes are paid. A C Corp's `[[net income]]` is after corporate taxes have been paid. To get a true picture of an S Corp's earning power, a savvy investor must adjust its earnings to an after-tax basis, similar to how one would analyze a C Corp's earnings. * **Capital Structure:** The 100-shareholder limit and restrictions on foreign or institutional ownership mean S Corps have a much smaller and less diverse pool of potential investors. This can make it harder to raise capital for expansion compared to a C Corp, which can have unlimited shareholders of any type. * **Focus on Cash Flow:** For an S Corp, analyzing distributions is key. Because of the "phantom income" issue, a company's policy on distributing cash to help shareholders cover their tax liabilities can reveal a lot about management's discipline and alignment with owners. A value investor should look for a balance between retaining cash for growth and distributing enough to cover shareholder tax burdens. ===== Pros and Cons at a Glance ===== ==== Advantages ==== * **Pass-Through Taxation:** The primary benefit is avoiding double taxation on corporate profits. * **Limited Liability:** Owners' personal assets are protected from business liabilities, just like in a traditional corporation. * **Clear Profit/Loss Allocation:** Profits and losses are directly passed to shareholders, providing a clear link between company performance and owner returns. ==== Disadvantages ==== * **Strict Requirements:** The limitations on the number and type of shareholders can restrict growth and access to capital. * **IRS Scrutiny:** The IRS tends to pay close attention to S Corp payrolls to ensure owners are paying themselves a "reasonable salary" (subject to payroll taxes) rather than trying to take all profits as distributions (not subject to payroll taxes). * **The "Phantom Income" Problem:** Shareholders are taxed on all profits, even those reinvested in the business, which can create a personal cash flow crunch.