Legal Definitions - Subchapter S corporation

A Subchapter S corporation, often simply called an S corporation, is a type of business entity that has elected a special tax status with the Internal Revenue Service (IRS). While it operates legally and structurally like a regular corporation, its profits and losses are treated differently for tax purposes.

The defining characteristic of an S corporation is its "flow-through" taxation. This means that the corporation itself does not pay federal income tax. Instead, the company's income, losses, deductions, and credits are passed directly through to its shareholders. Each shareholder then reports their share of these items on their individual income tax return, and pays taxes at their personal income tax rates. This structure is distinct from a "C corporation" (a regular corporation), where profits are taxed first at the corporate level and then again when distributed to shareholders as dividends (a concept known as "double taxation"). By electing S corporation status, businesses can avoid this double taxation.

To qualify as an S corporation, a business must meet specific criteria, including:

• It must be a domestic corporation.
• It can have no more than 100 shareholders.
• Shareholders must generally be individuals, estates, or certain trusts. They cannot be partnerships, other corporations, or non-resident aliens.
• It can only have one class of stock.
• Certain types of corporations, such as financial institutions and insurance companies, are ineligible.

A corporation elects S corporation status by filing Form 2553 with the IRS.

Examples of Subchapter S Corporations in Action:

• Example 1: A Small Family-Owned Consulting Firm

  Scenario: John and Maria decide to start a marketing consulting firm, "Bright Ideas Marketing, Inc." They are the only two shareholders and want the legal protection of a corporation, such as limited liability, but they don't want their business profits to be taxed twice. They anticipate distributing most of their profits to themselves as owners.

  How it illustrates the term: By electing S corporation status, Bright Ideas Marketing, Inc. avoids paying corporate income tax. Instead, the company's profits "flow through" directly to John and Maria's personal income tax returns. They report their share of the profits and pay taxes on them individually. This allows them to benefit from the corporate structure's liability protection while avoiding the double taxation that a C corporation would incur, fitting the criteria of having a small number of individual shareholders.

• Example 2: A Growing Tech Startup with Angel Investors

  Scenario: Four college friends launch "InnovateApp Solutions," a software development company. They incorporate to attract initial funding from a few individual "angel investors" who are also friends and family. The company is profitable early on and plans to distribute some earnings to its 10 individual shareholders. They are not yet seeking large-scale institutional funding from venture capital firms.

  How it illustrates the term: InnovateApp Solutions can elect S corporation status because it has fewer than 100 individual shareholders and only one class of stock. This allows the company's profits to be passed directly to the founders and angel investors, who then pay taxes on their share of the income on their personal returns. This structure is appealing to the individual investors as it avoids the corporate-level tax, maximizing their after-tax returns without the complexity of a partnership, and aligns with the S corporation's shareholder limitations.

• Example 3: A Professional Services Partnership Transitioning to Corporate Form

  Scenario: "Elite Architects," a successful architectural firm, has operated for years as a partnership with eight partners. As they grow, they decide to incorporate to gain better liability protection and a more formal structure for future expansion. They want to maintain a similar tax treatment where each partner's share of the profits is taxed only once, at their individual income tax rate.

  How it illustrates the term: By incorporating and then electing S corporation status, Elite Architects achieves its goals. The eight partners become shareholders, and the company's profits and losses flow directly to their individual tax returns, mirroring the single-level taxation they experienced as a partnership. This allows them to benefit from the corporate advantages like limited liability, while adhering to the S corporation's shareholder limits and avoiding the double taxation that would occur if they operated as a C corporation.