What Is a Sub S Corp?: Everything You Need to Know
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.3 min read
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.
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.
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.
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