The Internal Revenue Service (IRS) offers small business owners the opportunity to avoid corporate taxes while maintaining a level of liability protection not available to sole proprietors. In most operational measures, an S corporation operates the same as a traditional C corporation, and may be structured to allow multiple owners, limited issuance of stock and hiring employees. In fact, in nearly every aspect outside of taxation, S corporations are largely allowed to operate exactly as C corporations.
Limitations on S Corporation Assets
The IRS doesn’t limit the types of assets an S corporation may purchase in any way, so S corporations are free to invest excess capital into mutual funds or stocks in the same manner as C corporations. Likewise, S corporations may also invest in other assets not directly related to the daily operations of their business, including real estate and other companies. Although tax law doesn’t present barriers preventing S corporations from owning these types of investment assets, corporate ownership of them has much different consequences for S corporation owners than C corporation owners.
"Pass Through" Taxation
The IRS doesn’t require S corporations to file corporate income taxes. Instead, the corporation files a Schedule K-1, which reports earnings, and distributes the tax burden proportionately to its owners. This “pass-through” taxation applies to all income, including passive investment interest payments. When an S corporation receives dividends or interest on mutual funds it owns, it reports those earnings to the IRS as if each shareholder earned them. For tax purposes, investment income on S corporation holdings is treated the same as individuals owning the mutual fund. For example, if an S corporation with two equal partners invests $100,000 in a mutual fund and receives dividends, each partner will pay the same taxes as if he placed $50,000 of his own money into the same fund.
As with individual investors and C corporations, when an S corporation sells its shares of a mutual fund, it potentially faces capital gains taxes on the sale. In the case the fund’s shares were held more than a year, the IRS taxes the gains – or profit made on the sale – at a 15 percent rate. If held for a shorter period, gains rates are higher, and may be up to 35 percent, depending upon the asset. Because taxable income “passes through” from the S corporation to its owners’ individual income taxes, owners pay a proportionate amount of these gains when they file their Form 1040s.
Advantages of S Corporation Organization
Although individual owners may cringe at the thought of paying individual taxes on mutual fund earnings, the pass-through taxation allows small business owners to avoid double taxation that would occur on those earnings if the company was organized as a C corporation, which must pay corporate income taxes on gains and investment interest. In that scenario, a C corporation would pay income taxes on dividends; when it distributes dividends to shareholders, each would pay income taxes on their share.