Subchapter S (S Corporation)

What is a 'Subchapter S (S Corporation)'

A Subchapter S (S Corporation) is a form of corporation that meets specific Internal Revenue Code requirements, giving a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. The corporation can pass income directly to shareholders and avoid the double taxation that is inherent with the dividends of public companies, while still enjoying the advantages of the corporate structure. Requirements include being a domestic corporation, not having more than 100 shareholders, including only eligible shareholders and having only one class of stock.

BREAKING DOWN 'Subchapter S (S Corporation)'

Corporations filed under Subchapter S may pass business income, losses, deductions and credits to shareholders. Shareholders report such income and losses on their personal tax returns and pay tax at individual income tax rates. S corporations pay tax on specific built-in gains and passive income at the corporate level.

An S corporation must be a domestic company with individuals, specific trusts and estates as shareholders. Partnerships, corporations and non-resident aliens do not qualify as shareholders. Specific financial institutions, insurance companies and domestic international sales companies may not file as S corporations.

Advantages of Filing Under Subchapter S

Establishing an S corporation may help create credibility with potential customers, employees, suppliers and investors by showing the owner’s formal commitment to the company. Also, shareholders may be employees of the company, draw employee salaries and receive corporate dividends or other distributions that are tax-free in relation to each shareholder’s investment in the business. Characterizing distributions as salary or dividends may help the owner reduce liability for self-employment tax while generating business-expense and wages-paid deductions. In addition, the S corporation does not pay federal taxes at the entity’s level, the losses may offset other income on the shareholders’ tax returns. Saving money on corporate taxes is beneficial, especially when a business is newly-established. Also, interests in an S corporation may be transferred without facing adverse tax consequences, making adjustments to property basis or complying with complex accounting rules.

Disadvantages of Filing Under Subchapter S

The Internal Revenue Service (IRS) scrutinizes payments distributed to shareholders as salary or dividends as a way of ensuring characterization is realistic. Therefore, if wages are characterized as dividends, the business loses a deduction for compensation paid. Similarly, if dividends are characterized as wages, the business pays more in employment taxes. Also, mistakes in election, consent, notification, stock ownership or filing requirements may result in the S corporation being terminated. This rarely happens and is often quickly corrected. In addition, filing under Subchapter S requires time and money. When establishing an S corporation, the owner files articles of incorporation with the Secretary of State, obtains a registered agent for the business and pays the appropriate fees. In many states, owners pay annual report fees and/or franchise tax or other ongoing fees. The fees are typically inexpensive and may be deducted as a cost of doing business. Also, all investors receive dividend and distribution rights, regardless of whether the investors hold voting or non-voting stock.