Subchapter S Corporations – What Are They?
Subchapter S Corporations are a unique category of corporations created through an IRS tax election. By electing to be treated as S corporations, companies “pass through” their taxable income, deductions, and credits to owners/investors in the business. This way S corporations are able to avoid double taxation on the corporate income.
The S corporations are deemed more favorable to family-owned businesses or small-business owners, than standard C corporations, because of the appealing tax benefits and safety of business owners’ personal assets from company debt and judgments against the business. The formation of the S corporations in 1958 was a major step forward in eliminating an overwhelming double tax and promoting small and family business establishments in the United States.
The cost of an S corporation can differ. For instance, if an S corporation makes $600,000 in a given year, the business itself will not be taxed for that sum; instead, the company’s shareholders will be obligated to recompense taxes as per their share in the business. In this situation, if the company has three shareholders, each with an equivalent share in company stock, each shareholder will pay a tax of $200,000.
Criteria to Become an S Corporation
A corporation must meet the following criteria to be eligible for a subchapter S election:
- be a domestic corporation
- have not more than 100 shareholders.
- only have allowable shareholders (individuals, certain trusts, and estates but not partnerships, corporations or non-resident alien shareholders)
- only have one category of stock
- not be an ineligible corporation (certain insurance companies, financial institutions, and domestic international sales corporations)
Benefits of Subchapter S Corporations
- Limited liability: Company directors, shareholders, employees and officers enjoy limited liability protection
- Pass-through taxation: Owners account for their share of profit and loss on their individual tax returns
- Elimination of double taxation of income: Income is not taxed twice; once as corporate income and again as dividend income
- Tax savings: only the incomes of the Subchapter S Corporations shareholders who are an employee are subject to employment tax. The remaining income is paid to the business owner as a “distribution,” which might be taxed at a lower rate.
- Investment opportunities: The company can draw investors through the sale of shares of stock
- Perpetual existence: An S corporation title also allows a business to have an independent existence, separate from its shareholders. If a shareholder leaves the company, sells his/her shares, or passes away, the S corporation can go on doing business relatively unaffected. Maintaining the business as a separate corporate entity delineates clear lines between the business and shareholders that increase the safety of the shareholders.
- Once-a-year tax filing requirement (vs. quarterly for a C corporation)
Drawbacks of Subchapter S Corporations
- Stricter operational processes: Being a separate entity, S corporations require planned director and shareholder meetings, record from those meetings, agreement and updates to by-laws, stock transfers and records maintenance.
- Shareholder compensation requirements. A shareholder must collect reasonable compensation. The IRS takes into account the shareholder red flags such as low salary/high distribution combinations, and may reclassify distributions as wages.