Legal Definitions - S corporation

An S corporation is a specific type of business entity recognized by the Internal Revenue Service (IRS) that allows profits and losses to be passed directly through to its owners' personal income without being subject to corporate tax rates. This "flow-through" taxation means the corporation itself generally doesn't pay federal income tax; instead, the shareholders report the income or losses on their individual tax returns.

This structure is often chosen to avoid the "double taxation" that occurs with traditional corporations (known as C corporations), where profits are taxed once at the corporate level and again when distributed to shareholders as dividends. To qualify as an S corporation, a business must meet certain criteria, including having no more than 100 shareholders, all of whom must be U.S. citizens or residents (not partnerships, corporations, or nonresident aliens), and issuing only one class of stock.

• Example 1: A Family-Owned Consulting Firm

  Sarah and Tom, a married couple, own a successful marketing consulting firm, "Bright Ideas Inc." They are the only two shareholders and want to take their profits out of the business each year to reinvest personally or use for living expenses. By electing S corporation status, Bright Ideas Inc. avoids paying corporate income tax on its profits. Instead, the company's profits "flow through" directly to Sarah and Tom. They then report their share of the profits on their individual tax returns, paying taxes at their personal income tax rates. This prevents the business's earnings from being taxed once at the corporate level and again when distributed to them, thus avoiding double taxation.

• Example 2: A Small Tech Startup with Angel Investors

  Three software engineers, Alex, Ben, and Chloe, start "CodeCrafters Solutions," a company developing a new mobile app. They raise initial capital from five individual angel investors who believe in their idea. All eight individuals are U.S. citizens. CodeCrafters Solutions can elect S corporation status because it has fewer than 100 shareholders, and all shareholders are individuals (not other companies or partnerships) and U.S. citizens. This allows the company's early profits (or even initial losses, which can be beneficial for shareholders to deduct) to pass directly to Alex, Ben, Chloe, and the angel investors. This simplifies the tax structure for these individual investors, as they deal with the income or loss directly on their personal tax returns, without the company itself incurring a separate corporate tax liability.

• Example 3: A Group of Architects Forming a Practice

  Architects Maria Rodriguez and Kenji Tanaka decide to form a design practice, "Urban Blueprint Architects, Inc." They are the sole owners and practitioners, and they want to ensure that the practice's earnings are directly attributed to them for tax purposes. By operating as an S corporation, Urban Blueprint Architects, Inc. can distribute its net income directly to Maria and Kenji without the practice itself paying corporate income tax. Each architect will report their share of the practice's profits on their personal tax returns. This structure is ideal for professional service firms with a limited number of individual owners who are actively involved in the business and wish to avoid the additional layer of corporate taxation on their earnings.