Subchapter S corporation definition
/What is a Subchapter S Corporation?
A Subchapter S corporation is a form of corporate organization under which the obligation to pay income taxes is passed through to the shareholders of the organization. The "Subchapter S" term comes from the segment of the United States Internal Revenue Code (Chapter 1, Subchapter S) in which the rules governing the formation and operation of Subchapter S corporations is located.
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S Corporation Requirements
The Subchapter S type of organization is only allowed if an organization has 100 or fewer shareholders, is a domestic corporation (i.e., not foreign), only has one class of common stock, and only has certain types of eligible shareholders.
Advantages of an S Corporation
There are several advantages associated with the S Corporation legal structure, which are as follows:
Taxed as a partnership. An S corporation is taxed as a partnership, which eliminates the double taxation associated with a shareholder dividend from which a normal corporation suffers, where the company is taxed on its income, and then its shareholders are taxed on their receipt of dividend income from the company. Instead, all earnings of the business are passed through to and recognized by the owners on their individual tax returns.
Liability protection. The shareholders in an S corporation are protected from any liabilities incurred by the corporation. In effect, the corporation acts as a shield, so that creditors of the corporation cannot access the assets of the shareholders.
Simple conversion from C corporation. You can switch from a C corporation to an S corporation quite easily, just by filing a form with the IRS.
Disadvantages of an S Corporation
There are a few disadvantages associated with S corporations, which are as follows:
Restrictive eligibility requirements. An S corporation is subject to strict eligibility rules. It must have 100 or fewer shareholders, who generally must be U.S. citizens or permanent residents. Additionally, it can issue only one class of stock, limiting its flexibility in attracting investors.
Limited investor flexibility. Due to strict shareholder limits and restrictions on allowable shareholders (for example, partnerships, corporations, and nonresident aliens are not permitted shareholders), it becomes difficult for S corporations to attract institutional investors or raise substantial capital from diverse sources.
Single class of stock limitation. S corporations cannot issue multiple classes of stock with differing dividend or liquidation preferences. This restriction limits the company's ability to structure equity investments creatively or to attract investors who require preferred stock or special equity arrangements.
Closer IRS scrutiny. Because of its special tax status, the IRS tends to monitor S corporations more closely, especially concerning shareholder compensation and distributions. Increased scrutiny can lead to audits or investigations to ensure compliance with tax rules and regulations.
Complex profit and loss allocation. Profits and losses are passed through directly to shareholders based on ownership percentage, regardless of whether distributions are actually made. This may lead to shareholders owing taxes on income they have not physically received, creating tax burdens for shareholders without corresponding cash distributions.
Reasonable salary requirement. Owner-shareholders working actively for an S corporation must be paid a "reasonable salary," subject to payroll taxes. Determining a reasonable salary can be subjective, and underpaying may invite IRS scrutiny, audits, and penalties.
Administrative complexity. Operating as an S corporation involves administrative requirements, including annual meetings, minutes, documentation, maintaining records of stock transfers, filing tax returns at both the entity and individual levels, and tracking basis calculations for shareholders. These administrative burdens can become costly and time-consuming for small businesses.
Limited flexibility in allocating income and losses. Unlike partnerships and LLCs, which can allocate income, losses, and distributions flexibly among members, S corporations must allocate profits, losses, and distributions strictly in proportion to ownership percentages. This inflexibility might limit strategic tax planning options available to business owners.
While an S corporation can be beneficial, particularly for smaller businesses aiming to avoid double taxation, the limitations and disadvantages should be thoroughly considered before choosing this business structure.
Financial Reporting for an S Corporation
Because of the tax pass-through status of this type of organization, the business does not report an income tax expense on its income statement, nor does it report an income tax liability on its balance sheet.
Terms Similar to Subchapter S Corporation
A Subchapter S corporation is also known as an S corporation or an S corp.