S Corporation (S Subchapter)

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. If it does, it may pass income (along with other credits, deductions, and losses) directly to shareholders, without having to pay federal corporate taxes. Usually associated with small businesses (100 or fewer shareholders), S corp status effectively gives a business the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership.

Understanding S Corporations (S Subchapters)

To obtain an S corporation status, a business has to meet certain IRS requirements. These qualifications include:

Specifically, S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations (501(c)(3)). Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.

S corporations get their name from Subchapter S of the Internal Revenue Code, under which they've elected to be taxed. The key characteristic of a corporation filed under Subchapter S: It may pass business income, losses, deductions, and credits directly to shareholders, without paying any federal corporate tax — something known as a “pass-through” entity. It is liable on the corporate level for taxes on specific built-in gains and passive income, however.

S corp shareholders report income, gains, and losses from the corporation on their individual tax returns, and pay taxes at their ordinary income tax rates. Since the money comes to them free of corporate tax, o they avoid double taxation on any income or earnings.

Aside from its tax status, an S corp is similar to any other corporation, or C corporation as they're officially known. It’s a for-profit company, incorporated under and governed by the same state corporation laws. It offers similar liability protection, ownership, and management advantages as a C corporation. It must also observe internal practices and formalities: have a board of directors, write corporate bylaws, conduct shareholders' meetings, and keep minutes of significant company meetings.

IRS Form 2553

To create an S corporation, a business must first be incorporated.

It then must file Form 2553 with the IRS. Known officially as "Election by a Small Business Corporation," the form states that IRS will accept the S corp status only if the business meets all the qualifications for the status, "all shareholders have signed the consent statement, an officer has signed below, and the exact name and address of the corporation (entity) and other required form information have been provided."

Advantages and Disadvantages of S Corporations

Advantages of Filing Under Subchapter S

The big advantage of registering as an S corporation is the tax benefit: not having to pay federal taxes at the entity level. Saving money on corporate taxes is beneficial, especially when a business is in its early years.

S corp status can lower the personal income tax tab for the business owners as well. By characterizing money they receive from the business as salary or dividends, S corporation owners often lower their liability for self-employment tax. The S corp status generates deductions for business expenses and wages paid their employees too.  

S corp 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 — but these are taxed at a lower rate than ordinary income.

Other advantages include being able to transfer interests or adjust property basis, without facing adverse tax consequences or having to comply with complex accounting rules.

Finally, S corporation status may help establish credibility with potential customers, employees, suppliers, and investors by showing the owner’s formal commitment to the company. 

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 any distributions are made.

When it comes to making those distributions to stakeholders, the S corp must allocate profits and losses based strictly on the percentage of ownership or number of shares each individual holds.

If an S corp doesn't — or if it makes any other noncompliance moves, like mistakes in an election, consent, notification, stock ownership, or filing requirement — the IRS could terminate its Subchapter S status. This happens rarely, though. Usually, a quick rectification of non-compliance errors can avoid any adverse consequences. 

Filing under Subchapter S also requires time and money — or more precisely, the business of setting up a corporation does. The business owner must submit articles of incorporation with the Secretary of State in the state where their company is based. 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.

Finally, there are the qualification requirements. The limits on the number and the nature of shareholders might prove onerous for a business that's growing rapidly and wants to attract venture capital or institutional investors.

S Corp vs. LLC

A limited liability company (LLC) is another type of legal business entity. Like the S Corp, it's a common go-to structure for small businesses.

LLCs and S corps share other characteristics as well. Both are pass-through entities, meaning they don't pay corporate taxes, and both offer limited liability protection for their owners/principals, meaning the owners’ personal assets can't be touched by business creditors, nor can they be held personally responsible in lawsuits filed against the company.

However, LLCs are more flexible than S corps. They aren't subject to the IRS regulations concerning the number and type of shareholders/owners (called "members"), or to other federal or state rules regarding governance, procedure, and distribution of funds. They can allocate their profits and losses in whatever proportions the owners desire.

Easier to establish than S corps, LLCs typically are formed by sole proprietors or small groups of professionals, like attorneys, doctors, or accountants. However, their financing options are more limited — generally, to bank loans, as opposed to equity investors. This can limit their potential for growth.

U.S. Income Tax Return for an S Corporation

Although they are largely exempt from corporate taxes, S corporations must still report their earnings to the federal government and file tax returns.

Form 1120-S is essentially an S corp's tax return. Often accompanied by a Schedule K-1, which delineates the percentage of company shares owned by each individual shareholder, Form 1120-S reports the income, losses, dividends, and other distributions the corporation has passed onto its shareholders.

Unlike C corps, which must file quarterly, S corps only file once a year, like individual taxpayers. Form 1120-S is simpler than tax forms for C corporations, too. The version for 2020 ran five pages.

As long as a company elects S corporation status (and the IRS has accepted that election), it must file Form 1120-S. The form is due by the 15th day of the third month after the end of its fiscal year — generally, March 15 for companies that follow a calendar year.

Like individuals, S corporations can request a six-month extension to file their tax returns. To do so, they must file Form 7004: Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns by their return's regular due date.

S Corp FAQs

Why Would You Choose an S Corporation?

S corporations can be the best of both worlds for a small business, combining the benefits of corporations with the tax advantages of partnerships.

Specifically, S corporations offer the limited liability protection of the corporate structure — meaning an owner's personal assets can't be accessed by business creditors or legal claims against the company. But, like partnerships, they don't pay corporate taxes on any earnings and income they generate. They can also help owners avoid self-employment tax, if their compensation is structured as a salary or a stock dividend.

What Does S Corporation Stand For?

An S corporation is named for  Subchapter S of Chapter 1 of the Internal Revenue Code. It has elected to be taxed under this provision of the IRS code. S corps are also known as S subchapters.

How Does an S Corp Work?

In many ways, an S corp works as any corporation does. Operating under its home state's corporation statutes, it establishes a board of directors and corporate officers, by-laws, and a management structure. It issues shares of company stock. Its owners cannot be held personally or financially liable for claims by creditors or against the company.

S corps are distinguished by the fact that they are not federally taxed on most of the earnings they generate and distribute, leaving more money to pass to shareholders (who do pay taxes on the funds, at their ordinary-income rates). The funds must be allocated strictly based on the shareholders' equity stake or their number of shares.

S corps must restrict their number of shareholders to 100 or less, and these must all be individuals, non-profits, or trusts. These stockholders, along with the corporation itself, must be U.S.-based.

Come tax time, S corps must distribute the form Schedule K-1 to shareholders, indicating their annual profits or losses from the company, and file Form 1120-S with the IRS.

Which Is Better, an LLC or S Corp?

Whether an LLC or an S corp is better depends on the size and nature of the business and its aspirations for growth.

An LLC tends to be preferable for sole proprietors or enterprises with just a few partners, due to its flexibility and ease of establishment If a business is larger — or aspires to be — the S corp might work better. S corps have more financing options: Unlike LLCs, they are allowed to offer equity stakes to investors in return for capital, for example. And if their operations are complex, they would benefit from establishing the formal structures, compliance procedures, and other protocols required of corporations.

What Is the Difference Between S Corp and C Corp?

One key difference between S corps and C corps can be expressed in one word: taxes. In a nutshell, C corps pay them and S corps don't (mostly).

C corps pay corporate taxes on their earnings, the way individuals pay income taxes. (In the U.S., corporations are taxed currently at a flat rate of 21%.) Any dividends or other profits are then distributed to shareholders with after-tax funds. S corps, by contrast, are exempt from federal tax on most earnings — there are a few exceptions on certain capital gains and passive income — so they can distribute more gains to stockholders.

In return for this tax benefit, S corps face certain IRS-mandated restrictions. They and their shareholders must be domestically based. They can have no more than 100 shareholders, whose ranks are limited to individuals, non-profits, trusts, and estates — no institutional investors, in other words. And they can issue only one class of stock.

C corps do not have to comply with any of these restrictions. Generally (though not always) an S corp is smaller than a C corp.

The Bottom Line

S corporations are a common type of legal entity recommended for small businesses. They carry the tax advantages of partnerships while providing the limited liability protections of corporations. Sort of a corporate-lite structure, they are easy to establish and simpler to maintain than regular C corporations.

S corps do require many of the protocols and incur many of the costs associated with regular corporations — starting with the fees and formalities associated with incorporation. They are definitely more expensive to establish and time-consuming to maintain than limited liability companies, another popular small-business structure.

Though advantageous for fast-growing firms, they are also subject to certain restrictions on their size and shareholder by the IRS, which could eventually inhibit their expansion. The good news is, it's relatively easy for an S corp to change to C corporation status, should business conditions prove favorable to do so.