In the most basic sense, S corporations do not pay taxes on income. Rather, income, losses, deductions, and credits pass through the corporations to shareholders. S corporations provide shareholders with liability protection that comes with being incorporated, yet business profits and losses pass through to the owner’s personal income tax returns.

S corporations can be an especially good idea for start-up companies. For example, if new businesses sustain losses in some years, their owners can claim those losses in the current year of the loss on their personal tax returns.

There are other benefits to electing to be taxed as an S corporation. For example, if a taxpayer incurs interest in order to purchase S corporation stock, the taxpayer may deduct that interest as an investment interest expense. And when selling an S corporation business, the owners’ taxable gain on the sale may be less than it would be if the business had been a C corporation.

The IRS permits most but not all small businesses to incorporate as S corporations. In order for a small business to qualify for S corporation status, the business must meet these three requirements:

• It must be a U.S. company
• It must have only one class of stock
• It must have no more than 75 shareholders, all of whom must be legal residents or U.S. citizens and not also part of partnerships or other corporations

The tax reporting rules for S corporations are similar to those of partnerships. However, the IRS treats shareholders of S corporations as employees for payroll tax purposes. An S corporation must provide its employees a Schedule K-1, which lists the relative share of income or loss, deductions, and credits that must be reported on the employees’ income tax returns. And the IRS treats health insurance premiums paid by an S corporation for more than 2 percent stockholders as wages; these are deductible on Form 1120S by the corporation and reported to the stockholder on Form W-2.

However, there are limitations on deductions. For example, taxpayers may only deduct losses in the same amount that they put into their companies on their personal tax returns. Additionally, there is potential for problems when it comes to claiming losses from passive activities if taxpayers do not actively work in the taxpayers’ S corporation. These can only be used to offset passive income.