Definition of a Subchapter S Corporation

When learning about S corporation restrictions, it is important to know the definition of a subchapter S corporation. An S corporation is a business entity that has between one and 100 stockholders and benefits from pass-through tax status.  An S corporation is defined under the IRS Code Chapter 1, Subchapter S, which outlines the eligibility requirements for a corporation to allowed to be classified as an S corporation.

To qualify as an S corporation, a business must:

  • Notify the IRS of their intent to be taxed as an S corporation within a specific amount of time.
  • They must file their corporation's Article of Incorporation with the Secretary of State.
  • They must file an IRS Form 2553 stating their intent to become an S corporation.

An S corporation can not only be valuable to a business for tax purposes but also can be beneficial if it comes time for the business to be discontinued or ownership to be changed.

Taxation of a C Corporation

One of the most apparent differences between an S corporation and a C corporation is in the way that the corporations are taxed.  A C corporation is subject to double taxation, and its income is taxed at both the corporate and shareholder level. An S corporation, on the other hand, is a pass-through entity, so its income is only taxed at the shareholder level.

 A C corporation is required to file an 1120 corporate tax form and pays taxes based on the income they earned. A corporation has the right to keep its profits and earnings to be used as operating capital to the business or may choose to distribute their earnings to their shareholders in dividends. The shareholders of a C corporation will pay taxes on these dividends on their personal tax return. This creates a double taxation for C corporations as they will be required to pay taxes at both the corporate level as well as at the shareholder level.

Taxation of S-Corporations

One of the benefits of an S corporation is that it is not subject to corporate tax rates. In general, S corporations are exempt from any federal income tax except the tax on some passive income and capital gains. Instead of a corporate tax, an S corporation will use a pass-through taxation structure which will pass the taxation on its profits and losses to its shareholders.

Shareholders will be taxed based on the tax rates they qualify for on their 1040. By taxing income at only the shareholder level, S corporations avoid the double taxation that C corporations face. Similar to C corporations, S corporations are allowed to use profits as operating capital or distribute their profits to shareholders. Either way, the shareholder will be taxed on their portion of the business' tax liability even if they do not receive the dividends.

What Is the Eligibility Criteria for S-Corporations?

While an S corporation is a popular tax election for many types of businesses, there are criteria that need to be met before a corporation can be considered eligible for S corporation designation. Some of the criteria for becoming an S corporation include:

  • The company must be a domestic entity. 
  • All shareholders must be U.S. citizens. 
  • The corporation must file a Form 2553 with the IRS.
  • The company must be comprised of less than 100 shareholders.
  • All shareholders must fall under the classification of an individual, estate, exempt organization, or trust.
  • Shareholders cannot be nonresident aliens.
  • The company can offer only one class of stock (but they can offer both voting and nonvoting shares).
  • The company cannot be classified as an ineligible organization.
  • The company must adopt one of the following tax years: calendar year ending December 31st, a natural business year, the ownership year, a tax year selected under section 444, or another tax year selected for a business purpose.
  • All shareholders must consent to having the business classified as an S corporation.

The Advantages of an S Corporation

An S corporation has many benefits that far outweigh any disadvantages. Some of the advantages of classifying your corporation as an S corporation include:

  • Protection of the shareholder's personal assets.
  • Pass-through taxation prevents the double taxation of other corporate structures.
  • An easy transfer of ownership in the event of an owner's death or departure from the company.
  • The ability to use the cash method of accounting when the business does not have inventory.

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