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S-Corporations > Taxation - Pg. 26

First Steps 26 day basis. The shareholders elect a board of directors. The board of directors is responsible for the high-level strategic management of the company and makes most of the major decisions, including hiring (and firing) of officers. The officers (for example, the CEO, president, CTO) then manage day- to-day operations. Crucial decisions affecting the corporation, such as a sale of substantially all of the corporation's assets, are decided by shareholder vote. State statutes mandate certain officer positions, generally a president, treasurer, and secretary. In most states, one person can hold all positions and is not subject to any ownership qualifications. Taxation The S-corporation entity does not owe federal tax on its profits. All profits and losses flow through to its shareholders, who then owe income tax (or receive deductions) on those distributions at the shareholder's ordinary income tax rate. Note NOTE Owner-employees of anS-corporation may be eligible for reductions in theirself-employ- ment tax. Many investor/founders like the S-corporation as an initial choice because they can deduct some or all of the losses generated by the company from income they generate through other avenues. There are many restrictions on this practice, and it requires the counsel of a solid tax planner to accomplish effectively. Unlike the other pass-through entities (LLC and partnership), owners of an S-corporation may not decide amongst themselves how to allocate profits and losses; all profits and losses must be allo- cated by share ownership. Differential allocation is desirable in circumstances where, for instance, an S-corp will be generating tax losses for the first few years, and a large stakeholder (say, a founder) will not have enough income to use all of the loss, whereas a minority shareholder (say, an angel investor) will. Under the IRS rules regulating S-corporations, the minority shareholder will only be able to declare that portion of the corporation's loss corresponding to his or her ownership percent- age in the company. Quick example: Founder A owns 65 percent of the stock and earns $30,000 in income. Founder B owns 20 percent of the stock, but also works at another company and earns $400,000. The company generates losses of $100,000 in its first year. Founder A has a $65,000 loss that he can deduct from his income, but because he only has $30,000 in income, $35,000 goes unused. Founder B has a $20,000 loss that she applies against her $400,000 income, but she sure could use that extra $35,000 loss to deduct against her salary. Alas, she can't; Note CAUTION There are many assumptions andqualifications in this example--itshould not be used as a blanketapplication of the tax law. S-corporations do not allow for differential loss allocation. Two more limitations on using the S-corporation's losses: · A passive shareholder (one who does not work for the company) cannot deduct the losses from most income. The losses are considered capital losses and are only useful against the investor's capital gains. · Deductions are limited to the shareholder's basis in his stock. An easy way to think of basis is as your total cost paid for the stock. So if you have only paid $10 for your stock, you can only use $10 worth of deductions.