1. Definition of a Subchapter S Corporation
2. Taxation of Regular Corporations
3. Taxation of S Corporations

Definition of a Subchapter S Corporation

Understanding the requirements for S corporation can help business owners avoid legal issues and expensive, time-consuming business entity changes. An S corporation is a standard corporation with at least 1 shareholder but no more than 100. S corporations can also take advantage of pass-through taxation, which means that all net losses and income are passed through the business to the shareholders, based on IRS Code Chapter 1, Subchapter S.

All corporations must meet certain criteria to be eligible for this type of business formation. Additionally, the shareholders of an S corporation must submit a required form to the IRS within a specific period of time to elect this treatment. S corporations offer the appealing limited liability protection, along with perpetual existence and opportunities for investment. An S corporation is classified as a pass-through business entity. 

All corporations must be formed under the laws of the state in which they will operate. When a corporation is first formed, it is a C corporation by default. After filing the necessary formation documents with the proper state office, such as the Secretary of State's office, the shareholders must give consent to elect for treatment as an S corporation.

Since an S corporation is a type of corporation, it will be formed when its articles of incorporation are filed with the appropriate governmental agency. S corporations are governed in the same way as C corporations and can issue stock. Additionally, they have shareholders, officers, and directors who will perform the same business functions as those within C corporations. 

The owners of the company, or shareholders, maintain the same level of liability protection as those who own a C corporation. This means that the personal bank accounts or other personal assets of S corporation shareholders generally can't be taken to pay off or satisfy any outstanding liabilities of the business.

Taxation of Regular Corporations

A standard corporation, also referred to as a C corporation, is a business entity that exists separately from its shareholders for tax purposes. The term C corporation comes from the IRS Code, Chapter 1, Subchapter C. C corporation tax rates apply only to businesses formed as corporations. This type of business entity will also use its own specific IRS tax form, 1120.

Shareholders of a corporation can opt to retain earnings and profits as part of their operating capital. The other option is to distribute any or all of the earnings and profits, which are paid as dividends to the other shareholders of the company. These dividends, which are paid to the corporation's shareholders, are double-taxed.

The double taxation includes:

  • Corporate-level taxation, which is reported on IRS Form 1120
  • Individual-level taxation, which is reported on the shareholder's personal IRS Form 1040

The default tax status for all corporations is taxation as a C corporation. In order to change to S corp taxation, the shareholders must file a form to specify the tax status with the IRS. 

Taxation of S Corporations

S corporations are not subject to corporate tax rates. In general, S corporations are exempt from federal income taxes. The only exceptions with the IRS are on passive income and specific capital gains. Instead of being taxed on its income, the S corporation can pass its net losses and profits through the business to its shareholders. Each individual shareholder must pay taxes on the business profits on their personal tax Form 1040. Pass-through taxation, also referred to as flow-through taxation, ensures that the profits of a corporation are taxed one time, on the shareholders' personal tax returns.

As the IRS explains, the shareholders of an S corporation must include their share of any credits, losses, deductions, and income from the business. They must also report their shares of income or losses that are stated non-separately. Therefore, an S corporation can avoid the dreaded double taxation of its dividends.

Similar to a C corporation, an S corporation can elect to retain its net profits to keep as operating capital within the business. However, tax rules will apply in the same way as if the dividends were distributed to the company's shareholders. Therefore, shareholders within an S corporation could be required to pay taxes on income they didn't receive. This is one benefit of a C corporation since its shareholders will only have to pay taxes on dividends that have been paid out.

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