Key Takeaways

  • A Sub S corporation (S corp) is a tax election allowing small corporations to avoid double taxation by passing income and losses directly to shareholders.
  • To qualify as a Sub S corporation, the business must be domestic, have 100 or fewer shareholders, issue only one class of stock, and meet other IRS eligibility rules.
  • S corps combine the liability protection of a corporation with the pass-through taxation of partnerships or LLCs.
  • They provide several tax advantages—such as reduced self-employment taxes and potential tax savings through reasonable salary and distribution planning—but also come with strict operational and compliance requirements.
  • Shareholders must adhere to ownership limits, and S corp status can be terminated if the entity violates eligibility requirements or issues a second class of stock.

A Sub S corporation (S corporation) is a business that elects "small business" status allowing the corporation the benefit of limited liability, but the tax rate of the individual shareholder.

Overview of an S Corporation

To put it simply, a sub S corporation is a small C corporation that has met certain requirements and elects to be taxed as a pass-through business entity as per the Internal Revenue Code under Subchapter S.

Under Subchapter S, the corporation that has 100 shareholders or less can benefit from being taxed as a partnership. Additional requirements include the entity must be a domestic corporation, shareholders must be eligible to be part of the corporation, and there can only be one class of stock. Specific trusts and estates may also be shareholders.

Ownership interests in the corporations S corporation are transferable. This can be done without the corporation facing negative tax consequences, complying with accounting rules, or making an adjustment to property. It also means shareholders can sell their interests without the need for approval of other shareholders.

Those who do not qualify to be shareholders are non-resident aliens, corporations, and partnerships. Specific domestic international sales companies, financial institutions, and insurance companies may not file as S corporations.

To choose the subchapter S election, the corporation must do so no later than two months and 15 days after the first day of the entities taxable year. 

Eligibility and Formation Requirements for a Sub S Corporation

To qualify as a Sub S corporation under Subchapter S of the Internal Revenue Code, the business must first be incorporated as a C corporation or an LLC. Once formed, it can elect S corp status by filing IRS Form 2553 within two months and 15 days of the start of the tax year.

To maintain S corporation status, the entity must:

  • Be a domestic corporation organized in the United States.
  • Have no more than 100 shareholders.
  • Issue only one class of stock, though differences in voting rights are permitted.
  • Have shareholders who are U.S. citizens or residents, certain trusts, or estates—but not partnerships, corporations, or nonresident aliens.
  • Derive most of its income from active business operations rather than passive investment income.

Failure to meet these criteria or filing late can result in the loss of S corp status. Some businesses request late election relief by demonstrating reasonable cause for delay.

Advantages of an S Corporation

  • In a corporate structure, taxes are paid on the profits. The owners are then taxed on the dividends received, which results in the double taxation of the corporation.
  • With an S corporation, income is passed directly to its shareholders, which avoids the double taxation that involves the dividends distributed by public companies. The S corporation avoids the double tax while still maintaining the advantages of a corporate structure.
  • If the S corporation suffers a loss, the owner's share of the loss is passed through to be filed with the individual's tax return.
  • For small business owners, an S corporation is often more preferable than having a standard C corporation. 
  • S corporations provide the liability protection that comes with a corporation along with pass-through taxation afforded to partnerships and limited liability companies (LLCs).
  • A limited liability company's existence can expire; an S corporation does not.
  • It only takes one person to form a Subchapter S corporation.
  • Employee wages are subject to self-employment tax while other bonuses and benefits are not taxed.
  • As a separate entity, an S corporation retains the separate entity protection of a corporation along with the protection for owners against liabilities such as lawsuits or for being responsible for the corporation's debts, in many cases.
  • Liability protection is not guaranteed as it can be invalid if an owner commits acts that include them in the responsibility for actions of the corporation, or if the owner takes responsibility for guaranteeing a loan(s).
  • Shareholders may be employees, draw a salary, receive dividends from the corporation, or receive other tax-free distributions related to their investment in the business.
  • If an owner classifies distributions as dividends or salary, it may help reduce their liability for self-employment tax and at the same time generating deductions for business expenses and wages paid.

Tax Treatment and Shareholder Benefits

A Sub S corporation’s tax structure is one of its most defining advantages. Unlike C corporations, which are taxed at both the corporate and shareholder levels, an S corporation’s income and losses “pass through” to shareholders’ individual tax returns.

Key tax implications include:

  • Avoidance of double taxation – profits are taxed only once at the individual level.
  • Salary and distribution flexibility – shareholders who are employees can pay themselves a reasonable salary subject to payroll taxes and take additional distributions exempt from self-employment tax.
  • Deductible losses – shareholders can deduct business losses on their personal tax returns, subject to basis and at-risk limitations.
  • Qualified Business Income (QBI) deduction – eligible shareholders may deduct up to 20% of qualified business income, further reducing taxable income.

S corporations must still file Form 1120-S and issue Schedule K-1 to shareholders reporting each owner’s share of income, deductions, and credits.

Disadvantages of an S Corporation

There are two sides to everything and an S corporation is no exception as it has disadvantages as well as advantages. An S corporation must create and file the same paperwork applicable to a C corporation. This includes creating articles of incorporation, scheduling board of director meetings, keeping corporate minutes, and providing a means for shareholder voting.

There is quite a bit of additional paperwork involved with an S corporation that must be filed on a regular basis. A few of the forms include, but are not limited to, Form 4625 Depreciation, Schedule SE: Self-Employment tax, Forms 2553, 941, and 940, Schedule K-1, and an S corporation income tax return.

Along with filing its articles of incorporation with the Secretary of State, an owner must also obtain the services of a registered agent for the business, and pay any applicable fees. These may include annual report fees, franchise tax, or other ongoing fees.

Sub S Corporation in Mergers and Acquisitions

When a Sub S corporation is acquired, both buyer and seller must consider complex tax and structural implications. Acquisitions can be structured as stock purchases or asset purchases, each with different tax outcomes:

  • Stock Purchase: The buyer acquires the corporation’s stock and continues operating under its S corp status. The tax basis in assets remains unchanged.
  • Asset Purchase: The buyer purchases specific assets, often resulting in a step-up in asset basis, which can increase future depreciation deductions but may trigger capital gains for the seller.
  • In some cases, both parties can elect under IRC §338(h)(10) to treat a stock sale as an asset sale for tax purposes—allowing the buyer to gain a stepped-up basis while maintaining the S corp’s continuity.

These transactions must be carefully structured to avoid unintentional termination of S status, particularly when merging with entities that do not meet shareholder or stock class eligibility requirements.

Limitations and Common Compliance Issues

While a Sub S corporation offers valuable tax advantages, it must comply with strict IRS and state regulations. Violations can result in termination of S corp status, converting it back to a taxable C corporation.

Common compliance challenges include:

  • Maintaining a single class of stock – any difference in shareholder distribution rights can jeopardize S status.
  • Ownership violations – adding an ineligible shareholder, such as a foreign investor or a corporate entity, will automatically terminate S status.
  • Failure to distribute reasonable compensation – if owners take distributions instead of wages to avoid payroll taxes, the IRS may reclassify payments as salary and assess penalties.
  • State-level requirements – some states, like California, impose franchise taxes or annual fees even for S corporations.

Additionally, passive income limits apply: if passive investment income exceeds 25% of gross receipts for three consecutive years, the S election may be revoked.

When to Choose a Sub S Corporation

A Sub S corporation is ideal for small and medium-sized businesses seeking liability protection, investor credibility, and reduced taxation. It is especially useful for:

  • Professional service firms (e.g., consultants, medical practices, design firms).
  • Family-owned businesses with limited shareholders.
  • Businesses transitioning from sole proprietorships or partnerships wanting formal structure without corporate double taxation.

However, businesses planning to seek venture capital or public funding may find C corporation status more flexible for equity financing and multiple stock classes.

Frequently Asked Questions

  1. What is the difference between a Sub S corporation and a C corporation?
    A Sub S corporation is taxed as a pass-through entity, avoiding double taxation. A C corporation pays corporate income tax, and shareholders are taxed again on dividends.
  2. How does a business become a Sub S corporation?
    It must file IRS Form 2553 after forming as a C corporation or LLC and meet eligibility criteria like having 100 or fewer shareholders and one class of stock.
  3. Can an S corporation lose its status?
    Yes. Violations such as adding an ineligible shareholder or issuing a second class of stock can terminate S corp status.
  4. What taxes does a Sub S corporation pay?
    While it generally avoids corporate income tax, it may still owe state-level franchise or excise taxes, and shareholder wages are subject to payroll taxes.
  5. Can foreign investors own shares in a Sub S corporation?
    No. All shareholders must be U.S. citizens or resident individuals, qualifying trusts, or estates. Nonresident aliens and corporations cannot own S corp stock.

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