Subchapter S Corporation

Definition: A special form of corporation that allows the protection of limited liability but direct flow-through of profits and losses

The S corporation is often more attractive to small-business owners than a standard (or C) corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.

A corporation must meet certain conditions to be eligible for a subchapter S election. First, the corporation must have no more than 75 shareholders. In calculating the 75-shareholder limit, a husband and wife count as one shareholder. Also, only the following entities may be shareholders: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S corporations (but only if the other S corporation is the sole shareholder).

In addition, owners of S corporations who don't have inventory can use the cash method of accounting, which is simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid.

S corporations do come with some downsides. For example, S corporations are subject to make of the same requirements corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are also similar to those for a standard corporation. And S corporations can only issue common stock, which can hamper capital-raising efforts.

A corporation must make the subchapter S election no later than two months and 15 days after the first day of the taxable year to elect. Subchapter S election requires the consent of all shareholders.

The states treat S corporations differently. Some states disregard subchapter S status entirely, offering no tax break at all. Other states honor the federal election automatically. Finally, some states require the filing of a state-specific form to complete subchapter S election. Consult an attorney in your state to determine the rules that apply to your business.

An S corporation may revoke its subchapter S status by either failing to meet the conditions of eligibility for S corporations, or by filing with the IRS no later than two months and 15 days after the first day of the taxable year. Once the revocation becomes effective, the business will be taxed as a corporation.

When it comes to choosing the best structure for a business, many entrepreneurs have trouble making a choice between S corporations and LLCs--that's most likely because they possess similarities: They offer their owners limited liability protection and are both pass-through tax entities. Pass-through taxation allows the income or loss generated by the business to be reflected on the personal income tax return of the owners. This special tax status eliminates any possibility of double taxation for S corporations and LLCs.

That's where the similarities end. The ownership of an S corporation is restricted to no more than 75 shareholders, whereas an LLC can have an unlimited number of members (owners). And while an S corporation can't have non-U.S. citizens as shareholders, an LLC can. In addition, S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs or partnerships. LLCs are not subject to these restrictions.

LLCs are also more flexible in distributing profits than S corporations, wherein the corporation can only have one class of stock and your percentage of ownership determines the percentage of pass-through income. On the other hand, an LLC can have many different classes of interest, and the percentage of pass-through income is not tied to ownership percentage. The pass-through percentage can be set by agreement of the members in the LLC's operating agreement.

S corporations aren't without their advantages, however. One person can form an S corporation, while in a few states at least two people are required to form an LLC. Existence is perpetual for S corporations. Conversely, LLCs typically have limited life spans.

The stock of S corporations is freely transferable, while the interest (ownership) of LLCs is not. This free transferability of interest means the shareholders of S corporations are able to sell their interest without obtaining the approval of the other shareholders. In contrast, member of LLCs would need the approval of the other members in order to sell their interest. Lastly, S corporations may be advantageous in terms of self-employment taxes in comparison to LLCs.

For more information on the rules that apply to a Subchapter S corporation, talk with your CPA.

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