What is an S corporation? [S Corporation (S Subchapter)]

A s corporation, also known as subchapter S, is a type of corporation that meets the specific requirements of the Internal Revenue Code.

The requirements give a corporation with 100 or fewer shareholders the benefit of incorporating a partnership while being taxed as a partnership. The corporation can transfer the income directly to the shareholders and avoid double taxation.

Requirements include being a domestic corporation, having no more than 100 shareholders (eligible shareholders only), and having only one class of stock.

Key information

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

Understanding the S Corporation

Corporation taxes filed under subchapter S allow the business’s income, losses, deductions, and credits to be passed on to shareholders.

Shareholders report income and losses on individual tax returns and pay taxes at ordinary rates. S corporations pay taxes on specific incorporated earnings and passive income at the corporate level.

Shareholders of an S corporation must be individuals, specified 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 national international sales companies are also not eligible.

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

Advantages of Filing in Subchapter S

Registration as an S corporation can help establish credibility with customers, employees, suppliers, and potential investors by showing the owner’s formal commitment to the business. What’s more, the S corporation does not pay federal taxes at the entity level.

Let’s remember that saving money on corporate taxes is beneficial, especially when setting up a business. Other advantages are the transfer of interests in a s corporation without facing adverse tax consequences, the ability to adjust the basis of ownership, and compliance with complex accounting standards.

Shareholders can be employees of the company, earn salaries, and receive corporate dividends that are tax-free if the distribution does not exceed their share base.

If dividends exceed a shareholder’s equity base, the excess is taxed as capital gains.. Characterizing distributions as salary or dividends can help the owner reduce self-employment tax liability, while creating deductions for business expenses and wages paid.

Disadvantages of Subchapter S Filing

Because S corporations can disguise wages as corporate distributions to avoid paying payroll taxes, the Internal Revenue Service (IRS) examines how S corporations pay their employees..

An “S” corporation must pay reasonable wages to shareholder employees for services rendered before distributions are made.. While rare, noncompliance, such as errors in election, consent, notice, stock ownership, or filing requirements, can lead to termination of an S corporation. Prompt rectification of non-compliance errors can prevent any adverse consequences.

Filing Subchapter S Applications Also Takes Time and Money. When a s corporation, the owner files the articles of incorporation with the Secretary of State. The corporation must obtain a registered agent for the business, and pays other fees associated with incorporating itself.

In many states, owners pay annual reporting fees, a franchise tax, and various other fees. However, the charges are usually inexpensive and can be deducted as a cost of doing business. What’s more, all investors receive dividends and distribution rights, regardless of whether or not they have voting rights.

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