What Is an S Corporation (S Subchapter)?

An S corporation, also known as an S subchapter, refers to a type of corporation that meets specific Internal Revenue Code requirements. The requirements give a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. The corporation may pass income directly to shareholders and avoid double taxation.

Requirements include being a domestic corporation, not having more than 100 shareholders—which includes only eligible shareholders—and having only one class of stock.

Key Takeaways

  • An S corporation, also known as an S subchapter, refers to a type of corporation.
  • Requirements give a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. 
  • Corporate taxes filed under Subchapter S may pass business income, losses, deductions, and credits to shareholders.
  • Shareholders report income and losses on individual tax returns, and pay taxes at ordinary tax rates.
  • S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations.

Understanding S Corporations (S Subchapter)

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

S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). Partnerships, corporations, and nonresident aliens do not qualify as shareholders. Specific financial institutions, insurance companies, and domestic international sales companies are also ineligible.

Only individuals, specific trusts and estates, or certain tax-exempt organizations can be S corporation shareholders.

Advantages of Filing Under Subchapter S

Registering as an S corporation may help establish credibility with potential customers, employees, suppliers, and investors by showing the owner’s formal commitment to the company. Also, the S corporation does not pay federal taxes at the entity level. Saving money on corporate taxes is beneficial, especially when a business is established. Other advantages include the transfer of interests in an S corporation without facing adverse tax consequences, the ability to adjust property basis, and complying with complex accounting rules.

Shareholders can be company employees, earn salaries, and receive corporate dividends that are tax-free if the distribution does not exceed their stock basis. If dividends exceed a shareholder's stock basis, the excess is taxed as capital gains. Characterizing distributions as salary or dividends may help the owner reduce liability for self-employment tax while generating business-expense and wages-paid deductions. 

Disadvantages of Filing Under Subchapter S

Because S corporations can disguise salaries as corporate distributions to avoid paying payroll taxes, the IRS scrutinizes how S corporations pay their employees. An S corporation must pay reasonable salaries to shareholder-employees for services rendered before distributions are made. While rare, noncompliance such as mistakes in an election, consent, notification, stock ownership, or filing requirements, may result in the termination of an S corporation. Quick rectification of noncompliance errors can avoid any adverse consequences. 

Filing under Subchapter S also requires time and money. When establishing an S corporation, the owner submits articles of incorporation with the Secretary of State. The corporation must obtain a registered agent for the business, and it pays other fees associated with incorporating itself. 

In many states, owners pay annual report fees, a franchise tax, and other miscellaneous fees. However, the charges 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 have voting rights.