Key Takeaways

  • A sub S corporation (S corp) is a pass-through tax entity that helps small businesses avoid double taxation.
  • It must meet strict IRS requirements including limits on shareholders and stock structure.
  • S corps provide liability protection while offering tax efficiency, especially for owner-employees.
  • Not all businesses are eligible—banks, insurance companies, and certain foreign-owned businesses are excluded.
  • S corps must adhere to rules about shareholder compensation, stock ownership, and passive income limits.

What is a sub S corp? A sub S corp is a taxation status given to qualified small corporations and limited liability companies (LLCs) to protect them from federal double taxation. This taxation type is only available to entities with 100 or less U.S. shareholders. Corporate or business shareholders are not allowed in S corps. Subchapter S corporations are formed by filing the articles of corporation or the certificate of incorporation to the state, and they get S corp treatment by filing Form 2553 with the IRS.

Subchapter S Corporations: How They Are Formed

The process of the formation of subchapter S corporations is similar to that of C corporations. The process varies from one state to another, but it usually involves the following steps:

  • Registering a name with the secretary of state.
  • Appointing a registered agent for service process.
  • Appointing a board of directors.
  • Filing the certificate of incorporation or articles of incorporation.
  • Making corporate bylaws.
  • Holding the first board of directors meeting.
  • Issuing stock certificates.
  • Getting an Employer Identification Number from the IRS.
  • Opening a corporate bank account.
  • Getting state and federal permits or licenses.

The IRS initially gives all new corporations a C corporation tax status. Corporations that desire to change their tax status to subchapter S can do so by filing Form 2553 to the IRS. The form requires the following details:

  • The name and address of the corporation.
  • The EIN of the business.
  • The signatures of all the shareholders.
  • Tax year details of the business.

For the IRS to consider the application, the decision to file as an S corporation must be supported by all the shareholders. The form must be filed no later than March 15 for S corporations that follow the calendar year, or the first 75 days of the tax year for corporations that follow the fiscal tax year. The IRS will reply to the application within 60 days.

Requirements for S Corporation Treatment

Corporations and LLCs that want S corp treatment must meet the following requirements:

  • They must have 100 or fewer shareholders.
  • The corporation should not be a bank, an insurance company, a Domestic International Sales Corporation, or a former Domestic International Sales Corporation.
  • All the corporation's shareholders must be either U.S. citizens or U.S. residents.
  • The corporation must not have corporate or business shareholders. This means shares of the business should not be held by corporations, limited liability partnerships, LLCs, business trusts, and Individual Retirement Accounts.

Tax Benefits and Limitations of a Sub S Corporation

Sub S corporations offer significant tax advantages by allowing income, deductions, and credits to pass through to shareholders, who report them on their personal tax returns. This avoids the double taxation faced by C corporations. However, S corps must comply with specific rules to maintain this status:

  • Avoiding Double Taxation: Unlike C corporations, S corps don’t pay corporate income tax. Instead, profits are taxed only at the shareholder level.
  • Reasonable Compensation: The IRS requires S corp owners who perform services for the company to receive a reasonable salary, subject to payroll taxes. Excess profits after salaries may be distributed as dividends, which are not subject to self-employment tax.
  • Limitations on Loss Deductions: Shareholders can only deduct losses up to the amount of their investment and any loans they are personally responsible for.

Misclassifying compensation or failing to meet requirements may lead to IRS penalties or loss of S corp status.

Which Businesses Are Well Suited for Subchapter S Status?

Certain types of businesses have the potential to thrive as an S corporation:

  • Small C Corporations That Earn Big Profits. If a small C corporation has high earning shareholders, and the business makes profits regularly, owners should consider filing for S corp status. S corp status will enable them to save money that the corporation would otherwise spend on corporate tax.
  • C Corporations That Are Being Sold. A Corporation is likely to have less taxable gains when sold as an S corp than when sold as a C corporation. Some business owners file as S corporations to minimize taxes when selling the business.
  • Startups That Have Moderate Growth Goals. Although S corp status is not ideal for startups with big growth goals, startups that do not plan to expand quickly will likely benefit from filing as S corporations. An S corporation status will help them to save on taxes in the long run.

Sub S Corporation Shareholder and Stock Restrictions

To maintain compliance, sub S corporations must observe the following restrictions:

  • Shareholder Limit: No more than 100 shareholders are allowed. Spouses and certain family members may be treated as a single shareholder.
  • Eligible Shareholders: Only U.S. citizens or resident individuals, certain trusts, and estates can own shares. Partnerships, corporations, and foreign investors are ineligible.
  • One Class of Stock: S corps can only issue one class of stock, although voting rights may vary. This ensures equal distribution of income and loss.
  • Domestic Corporation Requirement: The company must be organized in the U.S.

These constraints are central to preserving sub S corporation status and ensuring pass-through taxation eligibility.

Characteristics of Subchapter S Corporations

A typical subchapter S corporation has the following characteristics:

  • Relatively Small. Many S corporations have a handful or a few dozen shareholders. Some S corps are small family-run businesses that do not have high growth goals.
  • They Are Not Passive Businesses. They are active businesses that have little or no passive incomes. The law discourages S corporations from having passive incomes, and the IRS will tax S corporations whose passive incomes exceed 25 percent of the corporation's total gross receipts. Therefore, S corporations are rarely investment firms or property holding companies.
  • Salaried Employee-Shareholders. The law requires S corporations to pay all their employee-shareholders at reasonable rates. This provision was made to prevent the S corporation employees from dodging payroll taxes. S corporations are the only major entity types that are required to pay employee-owners. Therefore, many S corporations pay good salaries to their employee-shareholders.

Sub S Corporation Compliance Obligations

In addition to formation and shareholder limitations, S corporations must maintain good standing by fulfilling several legal and tax obligations:

  • Timely Filing of IRS Form 2553: To elect S corp status, the business must file IRS Form 2553 within 75 days of formation or by March 15 of the tax year.
  • Annual Reporting: S corps must file an informational tax return (Form 1120S) and issue Schedule K-1 to each shareholder.
  • State-Level Requirements: Many states recognize S corp status, but some impose separate taxes or require additional filings. For example, California charges an annual franchise tax.
  • Recordkeeping: Accurate documentation of meeting minutes, stock issuance, and compliance with bylaws is critical.

Staying compliant not only avoids penalties but also maintains the limited liability and tax advantages of the S corp structure.

Frequently Asked Questions

  1. What is a sub S corporation?
    A sub S corporation is a tax classification allowing a business to pass income directly to shareholders, avoiding double taxation.
  2. Who can own a sub S corporation?
    Only U.S. citizens or residents, certain trusts, and estates can be shareholders—business entities and non-residents cannot.
  3. How do I form a sub S corporation?
    Form a corporation through your state, then file IRS Form 2553 to elect S corporation status.
  4. Can an S corp have more than one class of stock?
    No, S corps can only have one class of stock, though voting rights can differ.
  5. What happens if a sub S corporation violates IRS rules?
    Violations may result in termination of S corp status, leading to default C corporation taxation.

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