A corporation is an entity that is entirely distinct from its owners; it is legally described as an "artificial person". As such, it may own property, enter into contracts, borrow money, or be a party in legal proceedings, just as a natural person. Although corporations are often thought of as very large organizations, that certainly does not have to be the case. Any person can form a corporation. That person can be the sole owner or stockholder, and also serve as the corporation's president, secretary, treasurer or any other officer deemed necessary. Despite the tax advantages of incorporating, most people actually do so for non-tax reasons, such as to protect their personal assets from possible loss due to business obligations.

The U.S. tax code favors corporate business. As a result, even small incorporated organizations qualify for some corporate tax breaks that are unavailable to other business entities such as sole proprietorships, partnerships, or limited liability companies (LLCs). Generally speaking, however, only businesses which have solid profitability stand to gain a real tax advantage through incorporating. Typically, start-up and very small enterprises don't reap truly significant tax advantages from incorporating; the simplicity of a sole proprietorship, LLC, or partnership is often more desirable in these instances. Later, after the business has grown and become more profitable, incorporation may be a more attractive alternative.

While incorporation does offer potential tax savings, those advantages should be weighed against other factors, such as the more complex tax rules that apply to corporations as well as the higher costs of doing business as a corporate entity. Of all the organizational types, a corporation is the most expensive way of conducting business. Initial incorporation costs and annual fees to the state are required to maintain and operate a corporation, regardless of whether or not it makes a profit or even has an active status. Additionally, higher accounting costs and fees for professional help with federal and state corporate tax forms are commonly a part of a corporation's greater expenses.

For federal tax purposes, most corporations are classified as either "C" or "S" corporations (referring to the applicable subchapter of the federal tax code). All corporations begin their life as C corporations under the tax code. After the incorporation process, the stockholders may choose to move to "S" status if they prefer the organization to be taxed more like a partnership than as a regular C corporation, which is subject to different federal and state tax laws than those of partnerships, LLCs, and sole proprietorships.

Theoretically, all C corporations are subject to double taxation, which refers to business profits being taxed at both the corporate and individual levels. Before any profits are distributed to shareholders, the corporation must pay income tax on its earnings. Afterward, any profits received by the shareholders in the form of dividends are then subject to that person's individual income tax. In real-world situations, however, corporate taxes are usually avoidable by small C corporations, because all or virtually all of the business' earnings are typically paid out to its employees as wages and fringe benefits (which are deductible business expenses and not taxable as profits). After everyone has been paid, there's generally no income left for the company to owe any tax on.

C corporations have several tax benefits, but only after they're making a substantial profit. For instance, a corporation may lower its overall taxes by income splitting; that is, by dividing earnings between itself and its shareholders. C corporations can also make extensive use of fringe benefits, which are partially- or totally tax-free to the recipient and, as previously stated, tax-deductible to the corporation. Additionally, losses that the corporation incurs can generally be carried over to other corporate tax years to maximize their tax benefit.

Becoming an S corporation requires an additional step after the general incorporation process is complete. This step is called a tax election. C and S corporations are characterized by the way in which their income is reported. S corporations 'pass through' their profits to the shareholders, who pay tax on the income relative to their own individual income tax rates. This eliminates the possibility of double taxation on corporate profits. Thus, S corporations pay no federal income tax; they must still, however, file annual tax returns. And since business losses (which are common in the start-up phase of any organization) pass through as well, shareholders are also able to report them on their individual tax returns.

To be eligible for "S" classification, a corporation must be U.S.-based and have no more than 75 different shareholders (a husband and wife are considered to be a single stockholder if they own their stock jointly); this effectively eliminates all publicly-traded corporations from qualifying for "S" status. Additionally, all shareholders must be U.S. citizens, resident aliens, other S corporations, or electing small business trusts. The corporation may have only one class of stock; in other words, there can be no preferred or other types of shares that give special considerations to some shareholders. All shareholders must also consent in writing to S corporation status by signing a form that's filed with the IRS. Finally, the corporation cannot own 80 percent or more of the stock offerings of any other corporation.

Because profits pass through to its shareholders, an S corporation cannot retain earnings; in other words, it can't hold back any corporate profits to use for future growth or expansion. (C corporations often retain some of their earnings as a part of income splitting.) And because S corporations are usually small or start-up operations, they generally cannot afford to make use of fringe benefits to the extent that C corporations do.

Typically, shareholders take profits out of their S corporation either as wages or dividends. Regardless of form, the earnings are reported and taxed to the individual shareholders as ordinary income. Thus, an S corporation owner is taxed in the same manner as a sole proprietor, partner, or LLC member. Similarly, corporate operating losses are passed through to the shareholders as well, and can be used to offset other personal taxable income. However, the shareholder may not deduct losses greater than his or her tax basis in the stock personally owned. This basis is generally the total amount of money and property that the shareholder has put into the corporation for the stock.

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