What Is a Subchapter S Corporation?

A chapter S corp, also called a Subchapter S corporation, is a corporate tax status that provides limited liability protection and pass-through taxation. These benefits make the S corporation a popular choice for small business owners. With pass-through taxation, profits and losses are reported on each owner's individual income tax form and are not subject to corporate taxation.'

S Corporation Requirements

A corporation that wants to elect S corp tax treatment must meet these requirements:

  • Have 75 or fewer shareholders, with married couples counted as a single shareholder
  • Be owned only by individual shareholders, estates, certain types of trusts and partnerships, charitable organizations that are tax-exempt, and other S corporations provided the other S corp is not the only shareholder

If your S corporation does not have inventory, you can use the cash accounting method in which income is taxed upon receipt and expenses are deducted when they are paid. 

S corporation election must be done before two months and 15 days after the start of the tax year and requires all shareholders to consent in writing. S corporations must use December 31 as the end of the fiscal year.

If you do not maintain the S corporation eligibility conditions or fail to file with the IRS within the allotted time frame, this tax status may be revoked. This means your business will be subject to corporate taxation.

S Corporation Downsides

Downsides of an S corporation include:

  • Higher legal and tax costs
  • Required annual shareholders and directors meetings and meeting minutes
  • Shareholders must vote on major decisions
  • Only allowed to issue common stock, which can make it difficult to raise capital

Some states allow pass-through taxation for S corporations, while others require corporate income tax, thus subjecting the S corp to double taxation on state income tax. Other states require you to file a specific form for S corp treatment at the state level. Consult a business attorney familiar with the laws of the state where you plan to start your business.

LLC vs. S Corporation

Many business owners are torn between forming an LLC (limited liability company) or an S corp, as both provide pass-through taxation and limited liability protection. While an LLC can have unlimited owners, called members, an S corp is limited to 75 shareholders. Ownership of an LLC is open to non-U.S. citizens, unlike S corporation ownership. Other corporations, trusts, LLCs, and partnerships cannot own shares of an S corporation. While LLCs provide flexible profit distribution, an S corporation can only have one class of stock and distributions must be in accordance with ownership percentages. 

While most states allow an S corp to consist of just one person, some states require at least two people for LLC formations. LLCs have a limited lifespan, while S corps exist in perpetuity. Interests in an S corp can be freely transferred without shareholder approval, while LLC interests require member approval to be sold or transferred.

S corporations offer an advantage over LLCs when it comes to self-employment taxes. Because an S corporation can pay salaries to shareholders who work for the company, their taxable profit is lower even though they must pay 50 percent of each employee's FICA (Social Security and Medicare) taxes.

Filing S Corp Election

An LLC or corporation can elect for S corporation tax treatment by filing IRS Form 2553, Election by a Small Business Corporation. This form requires detailed information to determine whether your business is eligible for this tax status. If you make this election after the 15th day of the third month but before the tax year ends, the election will be in effect for the following tax year. 

If you need help with deciding whether S corporation election is right for your business, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.